Many of us are opposed to being in debt. I am no exception. Despite any logical argument I can frame for others, on some instinctual level, I do not like debt. And yet, I am going to try to convince you today to think twice before pre-paying your cheap debt.
Recently, I went through 2 months of training on debt. More than ever, I know that paying off cheap debt is a financial suicide. Let’s walk through some numbers and make it more scientific.
Here is the deal: you can pay off your mortgage, student loans, etc. and be free or you can continue making payments but be better off a few years down the road. Let me quantify this. Imagine you have a $400k mortgage with 20 years to go, a $20k car loan with 5 years to go and about $20k in student loans with 10 years to go…. your total monthly payment is about $3k. Let’s say your mortgage is at 4.25%, your car is at 1% and your student loans, at 4% (all realistic given our current interest rate environment). Let’s also imagine that you have an extra $200 per month to do whatever you want with. Here are 3 scenarios, see which one you prefer:
- Pay off the debt as scheduled (no extra payments). Invest the $200 you currently have for the next 20 years. Invest the $345 per month in 5 years (after you pay off the car); invest an additional $200 per month in 10 years after you pay off the student loans…. How much money will you have in 20 years, when your house is paid off?
- Pay off your student loans asap (the interest rate is 4 times as high on your student loans as on your car) first. Let’s put the extra $200 we have available into it until the loans are paid off. … and then once we are done with those, we will put all the extra money towards the house until we pay that off as well (the car will be gone pretty much at the same time as you finish paying off the student loans based on the accelerated schedule).
- Finally, let’s be realistic. No one has the self-discipline to put everything into paying off debt so instead of investing the $200 right now, we will spend it on stuff. Everything else is still the same as in #2.
Stay with me please… which one of the three is you? What will you do? Here is what would happen in each case:
- After 20 years, you will be debt free. I am going to assume a return of 5% on your investments. This means that in addition to no debt, you will also have about $205k.
- Your student loan will be gone after 4.5 years. At that point, we will put the extra $400 into the house. We will also add the $345 from the car (to be paid off in another 6 months) into the house. Your mortgage will disappear 15.5 years from now. You will have about 4.5 years left to invest the total amount. This means that at the end of 20 years, you will have about $181.5k available… Btw, just to be sure we are clear, that is $23.5k less than in scenario #1.
- Finally, let’s be human and spend the $200 on vacations, eating out and pedicures. Following scenario #2, we will be done with all debt in 18 years and have about $75k in our hands.
Do you see the problem? Let’s think about this. Let’s say you are 40 right now. In 20 years, you will probably still be working. So why in the world would you pay off the debt faster then?
As you look at yourself at 60, you are debt free no matter which path you take, but you can have an extra $23.5k in assets if you stop rushing to prepay your debt. And I assumed a 5% interest rate. Run the numbers with 6 or 7 percent and the difference becomes ever bigger.
I will leave you with 2 lessons that hopefully, put this conversation into perspective.
- Think hard about paying off your debt. Compare the interest rates you are paying and could be getting to make an informed choice. Negotiate with your spouse and insist on early investments rather than paying off the mortgage early.
- Ask yourself if spending $200 per month on whatever you are spending it now is worth not having about $150k in 20 years. This lesson has nothing to do with debt but it shows you that finding even a little bit money and investing it early on in your career is extremely beneficial long term.
But seriously, please stop paying off your 3% mortgage now and do something better with that money.
Inga Chira CFP®, Ph.D. is the Founder and President of Attainable Wealth, a Fee-only, virtual, comprehensive financial planning and investment management firm focused on serving the academic community.
Contact Inga: [email protected] (904) 994-0454
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