Many personal finance experts will advise you that getting out of debt is the best thing that you can do for your financial future. This is true in some cases. However, it is not always the smartest thing to do to use your spare money to pay ahead on all of your debt. You can be doing other things with the money to get yourself in better financial shape.
You Should Manage Your Debt Smartly
Of course, you should never let yourself get so buried under debt that bankruptcy is your last resort. Your debt should be managed. However, not all debt needs to be paid off immediately. While experts tell you that it is best to pay ahead on all of your debt, this is not the case for some types of debt. Allow us to explain further.
Many people simply group all types of money that you owe under the term “debt” and assign to it a negative connotation. This is accurate for some types of debt, but it is not correct for all of the money that you owe. Not all types of debt are created equal.
Credit Card Debt Is More Expensive
Credit card debt is not the same as owing money on your mortgage or student loans. When you owe money to the credit card company, you are likely paying interest rates that can average around 20%. The same holds true for other types of personal loans that carry higher interest rates. However, with other interest rates at an all-time low, you are not paying nearly as much on car loans and other types of credit.
It does not make sense to pay ahead on mortgage or student loan payments when it costs you so little to carry the loan. If you use your spare cash to get ahead on these loans, you are missing out on the benefits that you gain from liquidity.
You could take that money and use it to replenish and build your emergency fund. This may be a better option during a pandemic, when everyone’s job is seemingly at risk. It helps to have several months of living expenses saved.
Paying back debt just because someone told you that you should pay loans in advance will take away some of the liquidity that you would need if you found out tomorrow that you lost your job.
You Can Invest the Extra Money and Earn Income
Alternatively, you could take your money and earn a higher rate of return when you invest for dividends. It makes little sense to pay early when your interest rate is 4% when you can be earning 7-8% annually in the stock market. The opportunity cost of using your money to pay some debt early is more than you could save in interest payments for these loans.
To be clear, we are not saying that you should not pay back some debt earlier than is expected. We are saying that not every debt should be paid back early. For instance, we would advocate paying back as much of your credit card balance as you can at once. It makes no economic sense whatsoever to keep paying 20% or more annually if you have the money available to pay back this debt. However, it makes little sense to pay early on a loan that costs you 3% each year when you can be using your money to make more elsewhere.
Get a Handle on Each of Your Debts What you need to do is go through all of your debts and get a handle on what each is costing you to carry. You should group your debts into two different categories. The first category is debts that have high interest rates. You should make every effort to get ahead and make a dent in these accounts. The drop in financing costs that you will experience when you pay back these debts will increase your monthly income. The second category is lower interest loan debts. You need to do nothing with these other than to make your required monthly payments. Prioritize your debts to make sure that you are eliminating the most expensive ones first. This will not only keep you liquid, but it will allow you to spend even more money in the future to further trim these high interest rate debts.
