When it comes to paying down debt, we often focus on how much we can save in interest. However, we often forget that there are some types of debt that actually come with tax advantages. While it’s not exactly a dollar-for-dollar benefit, the reality is that the financial impact of interest can be reduced when you consider the tax-deductible nature of certain types of debt.
As you figure out what type of debt to pay down first, and as you consider whether or not it really makes sense to pay off your debt early, don’t forget to factor in the potential tax deduction, since you might actually be better off focusing on a different debt first, or putting your money to work using investments.
Business Debt
If you get a loan for business purposes, the interest you pay might be tax-deductible. Your business loan can be a way to help you build for the future, including allowing you to buy necessary equipment or smooth cash flow. It makes sense to consider keeping this debt for a little bit longer, especially if you want to give your business a fighting chance. Plus, some of the expense will be offset because you will receive a tax-deduction on the loan interest you pay.
Student Loan Debt
I took the maximum I could in student loans, even though I didn’t need them. However, I’m in no real hurry to repay them. First of all, my interest rate on my federal loans is below 2%, due to when I consolidated my loans. I can invest the money elsewhere and get a better deal.
Plus, student loan interest is tax-deductible (as long as you are eligible), and this means that my already low rate is effectively even lower. I see no reason to hurry up and repay that debt when the interest doesn’t really cost me much in real terms, and I could be doing something more profitable with the money.
Check into the eligibility requirements associated with the student loan interest tax deduction, and determine whether or not it makes sense to stick with the loan. You might be surprised to run the numbers and discover that having that debt isn’t quite a financial catastrophe (as long as you are comfortable with the payments).
Mortgage Debt
I recently sold my home, but I still paid mortgage interest for a good portion of the year. I’ll receive a tax deduction for that interest paid. And, like many people, the mortgage interest paid on a home loan is almost enough by itself to justify itemizing my deductions on the tax return, rather than taking the standard deduction.
Many people like the idea of paying off their home loans early, but it might not be in their best financial interests. The first step is to carefully consider the situation, and decide what makes sense. Run the numbers. What sort of tax deduction do you get to lower your interest rate? And is your rate already low enough that you could do better investing in your retirement account instead of paying down the mortgage debt?
Bottom Line
There are certain types of debt that is considered helpful to society, and that encourages people to build their assets. This type of debt comes with a tax break to encourage you to take advantage of it. As you try to figure out which debts to pay off, and how quickly you should pay them off, consider whether or not you are likely to receive a tax deduction, and make it a point to include that reality in your calculations. You might be better off, in terms of pure numbers, by keeping the debt a little longer.
