Lots of people are paying down their debt. It’s one of the major reasons the economy has been so slow to recover. Credit is a bit harder to come by (so are jobs, for that matter), so those who are buying are using cash more often instead of building any more debt; And those who aren’t, are saving. So the general advice for consumers is that right now is a good time to pay down debt.
But what if I told you paying down debt isn’t necessarily the best thing to do with your money? Even today. Just because it seems to be what everyone else is doing, doesn’t mean that it’s the right thing for you. And believe me, I get it, being debt free is a relief. But if you’re truly interested in how to stretch your dollar to its maximum, paying down debt may not (in fact) be the most frugal thing to do.
Everybody’s situation is unique
Just because it’s what most people are doing, doesn’t mean that it’s right for you. You need to look at your personal situation as your own. What kind of debt do you have? How much? What are the interest rates? How much cash or savings do you have? What’s your income? Is it steady/reliable? What opportunities for investment (personal or otherwise) do you have?
There is good debt and there is bad debt and there are a number of personal variables that can help determine which you have -and whether or not you should be focused on paying any of it down (vs. saving or investing). If you have bad debt, like high a interest credit card balance or a disproportionate debt payment-to-income ratio, paying down that bad debt certainly warrants a focus, especially now. Even what once would have been considered good debt can quickly become bad debt in a recession, like so many underwater mortgages have. Regardless, “good” debt still exists: low interest secured debts that don’t necessarily warrant principal reduction as well as [higher interest] debts, like student loans, that provide a return in the form of opportunity or capital gains.
Paying down debt vs. investing
I actually touched on this topic a bit last summer. There may come a time in your life when you have some extra cash or income and you’ll be confronted with a choice: invest it or pay down debt. And while most of the time the answer will likely be pay down debt, it’s not that simple.
Interest rates on loans work the exact same way the rate of ROI from investments work, compounded interest and all. Only: it’s in reverse. So given paying down a loan at 5% interest and investing the same amount of money at 5% ROI, over the same period of time, that initial amount would save the exact same amount in loan payments as it would have made in your investment portfolio. So for example, if your investment portfolio averages 4% return and you’re paying only 3.5% overall interest on your home loan (after tax deductions) it’s probably better to continue to invest your extra cash than pay down your mortgage principal.
So if you’re trying to figure out what to do with your extra cash flow, you need to compare interest rates on your loans and rates of return on your investments. Whatever has the highest rate will yield you the best return. But remember: investments have risk, especially if they are at a promised rate higher than most loans. Paying off debt is usually much more predictable investment.
Capital gains vs. principal reduction
A friend of mine told me a great story about how he recently saved his underwater mortgage. Just before the housing crash he bought his first house. Not having a lot for a down payment, he took a mortgage for a relative large amount. Fast forward to post housing bubble, and he owes more on the mortgage than his house was currently worth on the market. And while in and of itself, that wasn’t a huge problem for him (he had plenty of income), he figured out the best way to get “un-sunk” was to put more money into his home!
Because in his area, a number of contractors were out of work, he was able to hire one for a significant amount less than he would have pre-bubble. Materials, too, were in no short supply as a number of residential construction projects were suddenly and simultaneously halted. So for minimal cost, he built an addition to his home that added an extra master bedroom and a full bathroom. In all, the project cost under $10k, but added about $25k to the value of his home (going by his neighborhood’s current market value). That’s an added $15k in equity compared to simply paying $10k towards the mortgage. Which, consequently, would have just barely gotten him to even on the loan…
Savings and safety net
One reason people have started trending towards paying off debt rather than taking on more is the fact that the job market is so insecure. If at any moment you could lose your job in a market where they are scarce (to say the least) additional loan payments becomes…risky. But for those who might be looking to feel more secure and have some space in their current budget, paying down debt isn’t necessarily the best thing for you in the short term.
Savings is what’s important. Give yourself a safety-net – a sort of: self unemployment insurance. Enough to get by for, say 6 months or so on your regular bills. Sure, interest rates in savings accounts are terrible right now, so this certainly may not seem like the mos frugal thing you can do from an ROI perspective. But, if you do happen to suddenly need the money to pay bills from a loss of income, and it isn’t there… it’ll seem pretty frugal then.
Taking on more debt
If interest rates fall low enough, even if you can pay cash, it may actually be more frugal to take out a loan instead. I recently bought a new car. With good enough credit, I was able to get 0.9% financing. (My savings account yielded more than that!) So even though I could have almost paid for the car in full with cash, it actually made financial sense for me to take out a loan (and keep the cash in savings). If you qualify, home loans are at an all time low right now too…if you find a good house at a low price, now could actually be the BEST time to buy. (Do your research!!!)
Even if the interest rates are high, like they currently are for student loans, it might still make sense to take on debt to minimize lost opportunity costs. In other words, by not going to school you’ll probably earn a lower salary while having a tougher time finding work. In the long-run it will cost you to NOT take out the loan.
Consider all costs
Being frugal means considering all the costs (and future costs) of your monetary decisions. And while comparing interest rates may seem cut and dry, there are a number of other factors to consider. Just to name a few:
- Variable interest rates
- Loan refinancing
- Loan forgiveness
- Tax deductible interest
- Risk (investments)
For my friend who’s house went up in value $25k, it may cost him in:
- property taxes
- school taxes
- homeowners insurance
- maintenance costs