This post is part of our financial myths series
You may have heard that it’s always better to pay down debt as fast as possible. There are two huge flaws with this advice.
Here are some factors to consider.
What do interest rates look like?
What if you were able to take out a loan at 2.5%? And, what if at the same time you were able to generate 5% on your investment portfolio? Does it make sense for you to take funds that could be in your investment portfolio and earning 5% to pay off the loan at 2.5%? Possibly not.
Considering things like mortgage interest deductions and barring any additional costs of carrying the loan, you will come out financially ahead by taking your time to pay down that 2.5% loan.
Money is extremely personal
Money and finances are extremely personal matters. Your money story and your history with money is different than anybody else’s. For some people, having any kind of debt induces anxiety. It doesn’t matter if they could pay off their debt 10 times over and there is little or no chance of having their home foreclosed upon, their car repossessed or having levies on their income, they just don’t like having debt. In these cases, it really may be the best thing for these people to pay down their debt as fast as possible. It’s very hard to put a price on personal contentment-or determine the cost of personal anxiety.
Risk tolerance
For some folks, there is a great deal of uncertainty about their financial situation. For instance, their income might be very variable – changing from month to month and year to year. Those folks are already tolerating risk in their variable income. They may not want to take on the additional responsibility of those principal and interest payments. In those cases, it might be helpful to pay down debt when the cash is flowing. That can help reduce fixed payments and make life a little easier during those low-income periods of time.
The same thing goes for those who are getting ready for retirement. If cash and income needs during retirement will be met easily, then it may make more sense to look at this question with strictly black-and-white benefit and cost numbers. In other words, if the return on investments is significantly higher than the cost of interest on the loan, it may make sense to pay off the loan slowly. Use those funds to get the higher return on investment. Use part of that return to pay the interest, and you still come out ahead. On the other hand, if there is uncertainty about steady income during retirement, and especially if we are talking about the family home, you may want to have any indebtedness on the home paid off prior to retirement. Yes, there will still be ongoing expenses related to owning the home like upkeep and property taxes, but at least the monthly mortgage payments could be eliminated.
For the most part, we are talking about debt with fixed interest rates. There is additional risk if the interest rates are variable. Variable mortgage rates, credit card debt and lines of credit often come with variable interest rates. This means that while you may have felt that a monthly payment was reasonable when you took on the loan, and increased payment due to higher interest rates could be crippling. In those cases, the simple financial calculation showing costs and benefits needs to be balanced with the additional risk.
Using leverage
Remember, this is intended to be educational – not advice. In direct contrast to the notion that you should always pay down debt as quickly as possible, many successful investors actually take on debt just to build their investment portfolios. In other words, if they believe that they can get a better return on their investments than the cost of borrowing money to make those investments, they choose to incur the debt. They may do this even if they had cash readily available to make those investments. Because on the spreadsheet, with just black and white numbers, it shows a positive return. Again, this is just for educational purposes, not advice. These investors are taking on a serious amount of risk. They could lose their own money as well as borrowed money which they still have to pay back – with interest. But again, this strategy flies in the face of the notion that one should reduce their debt as quickly as possible.
I think the most important factor here is that money is very personal. Everyone handles money differently. Money affects different people differently psychologically. Some people get anxious having any kind of debt, while others look at it strictly as a tool to grow their wealth.
I think this is a prime example of making sure you are making informed decisions. Calculate the actual financial cost of carrying the debt versus any potential gain on the use of those funds. But ultimately, it comes down to how much risk you can tolerate and how comfortable you are holding that debt.