Your Best Bet: Pay Down Debt

(MoneyWatch)  The Consumer Price Index numbers just came out for July and again we're seeing year-over-year declines for inflation. With prices and wages falling, your best bet for any spare cash may be to pay down debts.

According to the CPI, prices fell about 2.1 percent between July 2008 and July 2009. This is the first time that has happened since 1950. Moreover, because of falling prices and a weak economy, there isn't much wage pressure on employers, meaning that you may not see your pay go up any time soon.

So if your income isn't growing, a good use of your money may be to pay down your outstanding debts. Why? Because your debts are generally fixed expenses. Usually, if your wages are growing, over time you get to pay off your debts with "cheaper money" because of inflation.

Here's an example:

• Assume you make $100,000 and your annual mortgage payments total $20,000.
• If your wages grow over a 10 year period to $125,000, your mortgage payment would stay the same at $20,000 a year (assuming you have a fixed rate mortgage).
• So in a sense it gets cheaper each year to pay off your mortgage because the payment is falling as a percentage of your total pay.

But if your income isn't growing or is actually shrinking, then accelerating your debt payments could be a good strategy. When you pay off debt, the return is equal to the interest payment that you don't need to make by paying off the debt early.

• For example, if your mortgage is at 6.25 percent, then paying it down provides you with a 6.25 percent return on the money you used to pay off the debt. And if your income goes down by say 2 percent, then by paying off a chunk of your mortgage early, you're creating another 2 percent of real return when compared to your declining income.

I don't know whether or for how long these deflationary pressures will last, but one economist I like to follow is Gary Shilling. In one of his recent reports, he indicates that deflationary pressures may last longer than most people think. Gary had been warning readers for several years about the coming housing crisis and deflationary pressures it would create, so his opinions deserve some weight.

• He's concerned from a macro-economic standpoint that consumers will choose to pay down debts in this type of environment. While that may hold back growth of the overall economy, it may be the right thing for you to do within your own household.

Now I don't mean to suggest you should stop saving for retirement and just pay down debt. But given the unusual situation we have with deflationary pressures, if you have some additional funds you can dedicate to your long-term retirement planning, a good use of the money may be to pay down debts.

Remember, you want to be debt free by the time you retire. So reducing debt is a major step toward creating the foundation for a secure retirement.

Bottom line. Given the uncertainty in the stock market and the downward pressure on wages, paying off a little extra debt may provide you with a pretty solid return on that money over the next few years.

As with all financial matters, consult your individual advisor prior to making any financial decisions.