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Hong KongDebt: which to attack first, and when refinancing pays
Highest interest rate first is mathematically optimal; smallest balance first often wins behaviourally. Refinancing pays when the interest saved exceeds the costs within the period the client will hold the loan.
Two questions here: which debt to attack, and whether to refinance. Both have a mathematical answer and a behavioral one, and the exam tests whether you know when each applies.
Avalanche or snowball
| Avalanche | Snowball | |
|---|---|---|
| Order | Highest interest rate first | Smallest balance first |
| Total interest paid | Lower | Higher |
| Time to debt free | Shorter | Longer |
| Early wins | Few | Many |
| Completion rate in practice | Lower | Higher |
Avalanche is correct arithmetic. Snowball is often correct behavior, because a plan a client abandons saves nothing. Both are defensible.
Where a question emphasizes motivation, discouragement or previous failed attempts, it is asking for the snowball. Where it emphasizes cost, it is asking for the avalanche.
Debt that is not worth accelerating
Low-rate debt, particularly where the money could earn more elsewhere with an acceptable risk. A mortgage at a low fixed rate against an unmatched retirement contribution is usually a straightforward case for the contribution. Compare the alternatives.
Deductible debt shifts the comparison too, since the after-tax cost is lower than the nominal rate. Whether interest is deductible depends on the debt type and the client's circumstances.
An employer match is an immediate return no debt repayment matches. A question offering aggressive debt repayment while leaving a match uncaptured has the answer built into it.
Refinancing
The question is break-even: the closing costs divided by the monthly saving gives the number of months before it pays.
If the client will move or repay before then, it does not pay. Rate difference alone does not answer it, and questions supply a holding period precisely to see whether you use it.
What refinancing hides
- Resetting the term. Refinancing a mortgage with twenty years remaining into a new thirty-year loan lowers the payment and raises total interest.
- Rolling costs into the balance rather than paying them.
- Converting unsecured debt to secured, which lowers the rate and puts the house at risk.
- Prepayment penalties on the existing loan.
The third is the one to be careful with. A home equity loan to clear credit cards reduces the rate and changes the consequence of default entirely. The house is now collateral.
Every dollar limit here is indexed annually and several were changed by recent legislation. Confirm the current figure against the IRS or the relevant authority before relying on it, and expect the exam to test the rule rather than the number.
Common questions
Should you pay the highest rate or smallest balance first?
Highest rate is mathematically optimal. Smallest balance often works better behaviourally, and a plan a client abandons saves nothing - so the scenario decides.
When does refinancing pay?
When closing costs divided by the monthly saving is shorter than the period the client will hold the loan. Rate difference alone does not answer it.
Should you always pay off debt before investing?
No. Capture an employer match first, since it is an immediate return no repayment matches. Low-rate or deductible debt may also be worth carrying.
What is the risk in consolidating cards into a home equity loan?
It converts unsecured debt to secured. The rate falls and the consequence of default becomes the loss of the house.
What debt ratios does the exam use?
Housing costs around 28 per cent of gross income and total debt payments around 36 per cent. Both are conventions rather than rules and are applied with judgment.