A common dilemma some individuals have is how much they should put aside for savings and how much they should use to pay off debt. It is something we all face, so it begs the question… what is more important?
My personal opinion on this is paying off debt is almost always more important. There are a few instances that this isn’t true but I’ll get into that later in the blog.
So why is paying off debt better than putting money away for savings? Well in most situations, the money that you make off investing/saving your money is not as much as the interest (cost) that you might incur from that debt/credit that you have.
Let me give you an example.
Let’s say you have the ability to invest your money in a mutual fund that might earn you 5% interest. That’s not bad. So that $1000 you invested could earn you $50 for the year and will continue to grow.
However let’s say you have debt on your credit card of $1000, with an interest rate of 19.99%. Well if you don’t pay that off, it will cost you around $200 in interest for the year.
Ok… how about another example whereby that debt is on your line of credit which might have a much lower interest rate. Currently mine is around 7%, which means that $1000 debt would cost me around $70 for the year. So in both situations I would be worse off investing my money.
So I would only invest my money if I knew I could earn more than 7%, which is hard to find and is never guaranteed. However paying off that debt would guarantee me a return of 7%, because I know I wouldn’t be incurring that interest cost of $70.
It can be simple math that some people ignore because paying off debt isn’t as sexy as investing their money. So take my word for it… pay off debt first!!!
So what debt would I not pay off instead of investing??
Any debt that was purchased using a very low financing rate like my car or mortgage is something I wouldn’t pay off. My car was purchased with 0% financing. So if I pay it all off now or over the next 5 years, I would be paying the same amount. So no point in paying the loan off early.
So what about my mortgage? Well I do like putting extra money towards my mortgage but only if I don’t have any other debt. It’s a very nice to do and not something most people should be doing if they have other debt. Also, you really won’t realize much cost savings by doing this in the short term. So better to use that money to pay off other debt, or invest it in something like renovations to the house that will make you money long term.