If there’s one personal finance tenet you’ll see almost universal agreement on, it’s that you should pay off your high interest debts first and keep them paid off. Accumulating high interest debt is devastating to your finances because of the sheer amount of money that it drains from your checking account with nothing in return.
What about low interest debts, though? What if you have a debt that’s locked in at 3% or 4%? Does that debt need to be paid off, too? Also, where exactly is that line between high and low interest debt?
Before we dig in, let’s be clear about the benefits of making extra payments on a debt. When you get a bill for a debt in the mail, there are two key numbers you’re looking at. The first is the principal or balance, which is how much you currently owe. The second is the interest. That’s how much extra you owe that’s built up since your last payment. It’s based on multiplying your principal by the interest rate.
For example, if you owe $1,000 at a 12% annual interest rate, and you’re making payments once a month, your interest on your next payment will be $1,000 times 0.12 (that’s 12%) divided by 12 (because it’s one month out of the 12 months of the year), meaning you owe $10 in interest.
This is important because the amount of interest you owe each month goes down when you pay off principal. If you reduce that principal to $500, you only owe $5 in interest that month. Extra debt payments go entirely to the principal, making it that much smaller. Thus, when you make an extra debt payment, you’re lowering the amount of interest you pay every single month going forward (assuming you don’t add more to that debt). That’s why it’s so powerful!
What is a “low interest debt”?
A low interest debt is any debt with an interest rate lower than what you could easily get with an investment. Depending on your perspective on investments, that number is somewhere between 7% and 12%. Warren Buffett projects that future investment returns should come in around 7% a year, so 7% is a pretty safe cutoff between low and high interest debt.
You should pay off high interest debt as fast as possible, because you essentially can’t do better than that through investing without some significant luck. It’s a pretty good guaranteed rate of return on your money (assuming, again, that you’re not accumulating any more high interest debt).
With low interest debt, it gets a bit trickier, as there are both pros and cons to paying off low interest debt early. Some people even consider low interest debt to be “good debt” because of some of the drawbacks.
Pros of paying off a low interest loan early
Benefits of paying off a low interest debt early include:
- Fewer monthly bills, which means less financial stress any way you slice it. Simply having to come up with less money for bills each month is always a help.
- Improved cash flow, which happens as a result of shrinking or eliminating bills. If you pay off any debt, you have a smaller stack of bills to pay off each month, which means that you can survive and thrive on a smaller amount of income or have more money available to save for long-term goals.
- Financial progress happens even when you pay off a low interest debt. That’s money that’s not disappearing in the form of interest.
Cons of paying off a low interest loan early
Drawbacks of paying off a low interest debt early include:
- Locked-up money, because money that could have been easily available in a savings account is now “tied up” in your loan. For example, you could have a $5,000 debt and $1,000 in savings, or a $4,000 debt and $0 in savings. While it’s nicer to have lower debt, it also means you don’t have that $1,000 easily accessible for emergencies, and that could turn quickly into credit card debt in an emergency.
- Opportunity cost, which is an extension of the ‘locked-up money” problem. If you pay down a debt, that means that you don’t have the cash on hand to take advantage of an opportunity. If you put that $1,000 into a loan, you might not have $1,000 to take advantage of a great deal on replacing your fridge that’s nearing the end of its lifespan.
Don’t pay off a low interest loan early
If you do not have any other financial plans, the best strategy is to pay off high interest loans first, then make minimum payments on low interest loans and do other things with what would have been an extra payment, like building an emergency fund or bumping up retirement contributions.
An emergency fund is useful because it’s a buffer that keeps you from taking on high interest credit card debt in an emergency. For example, if your car breaks down and needs to go to the shop, you can just tap a cash emergency fund instead of putting a balance on a credit card. This should be a top priority once you have high interest debt under control.
If you have an emergency fund, transition to making sure that your retirement savings are well taken care of. Bump up contributions to your workplace retirement plan. If they offer matching funds, contribute enough to get every dime of it.
Except in these situations
Are there times when you should consider paying off a low interest loan quickly? The only time you should consider such a move is when you already have an emergency fund and you know that your monthly income is about to drop.
For example, if you have a few months of living expenses saved up and you’re considering a career change or a job change, then having lower monthly bills makes it much easier to move into a period where there might be less income moving in. Another example is if you’re about to retire with a fixed income, such as a pension, where you know that your monthly income will be lower and month-to-month survival is much easier if you have fewer bills.
In those situations, however, you should prioritize a healthy emergency fund over paying off low interest debt. Only pay off the debt if you have a few months of living expenses set aside in case things go badly.
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