If you read my prior article on the 8 ways in which you can reduce your debt, you are now probably burning with desire to start chiseling away at what you owe. So, you might be wondering why I am saying NO to paying off debt in this article.
Is it because I can’t make up my mind? Am I encouraging you to blow your remaining life savings on a cruise to Belize? Well, no. What I am trying to do is to rein in your natural desire to pay off your debt by sacrificing higher returns from other investments, or by accumulating higher interest rates from other debts. It does no one any good if you actually make yourself poorer by paying off your debt.
Confused? Then read on.
In this article, I outline several occasions where paying off debt, and especially paying off debt sooner than it is due, is a bad idea. Here is the first:
- When It Involves Your Mortgage.
With mortgage rates at an all-time low, you simply cannot refuse getting your previously high rate refinanced. Even better, if you are currently buying a home, not only will you get that home at discount, but you’ll obtain financing at a super low rate.
That’s the good news. The bad news is that many folks, as soon as they take a look at their mortgage papers, start panicking about how much interest will be paid. It’s no joy to look at your mortgage repayment plan and find out that, with all that interest, you could’ve purchased another home- or even two.
And so, instead of thinking about the fact that all that interest is tax-deductible, these good folks start going on a repayment rampage, sending the mortgage lender any additional money that is stashed away. Alternatively, many folks take on 15-year or even 10-year loans, becoming house-poor just for the sake of seeing the principal take a significant hit every month.
While it is satisfying to know that you are paying more principal than interest on your loan, keep in mind that all that extra money being sent in could be used elsewhere. For example, many dividend stocks pay 30% or more each month on their price per share. There may be a tax lien property around the corner that could result in a free house (for more info, check my article on tax lien property). Likewise, if you are 50+ years of age, retirement (and your IRA) should be the first thing on your mind. And speaking of which…
- When It Involves Your Retirement.
If you are neglecting your 401(k) or IRA in favor of paying off your mortgage, your personal loans, your student loans, etc., stop doing that right now. You may reason that your retirement account’s interest rate is nowhere near the interest rate on your car or personal loan. While that may be true, there are other things here that you have not considered: time and free money.
An IRA, such as a traditional IRA, generates interest from your pre-tax dollars, then uses that interest to generate still more interest. Year in and year out, your interest accumulates, or compounds, becoming significantly more than it is today.
For example, take the case of a person who is 37 years of age, in the 28% tax bracket, and who is setting aside $2,000/year for the next 30 years in a traditional IRA. The average interest rate on the IRA stands at 8% (historically, stocks rise 11% annually, but due to the current economy, I’ve lowered the percentage by 3 points). This person spends $60,000 to invest in his/her IRA, which grows to almost $226,566.42. When the IRA is taxed and withdrawn, this person receives back $163,127.82. That amounts to $63,438.60 in compounded interest.
Now, consider the same person putting that additional $2,000 into a home mortgage once a year. On a traditional 30-year home loan of $200,000, at a rate of 5%, the extra $2,000/year will reduce total interest from $186,511.57 to $134,274.45, a savings of $52,237.12.
While the extra $11,201.48 is impressive in itself, consider also that, if you are lucky enough to have your employer contribute to your 401(k), a good chunk of your original $60,000 investment is a gift. For example, if your employer is matching 50% of 6% of your salary contributions, and you earn $40,000/year, that’s a free $666.67 each year that you contribute with your $1333.33 (keeping with the original $2,000/year investment). So, over the course of 30 years, you end up contributing just under $40,000 for that post-tax 401(k) now worth $163,127.82.
- When It Involves Your Investments.
Yes, the dismal states of the NYSE and the NASDAQ would make anyone cry right about now, but there are foreign markets and stocks that are not doing too badly. For that matter, even some American stocks are doing quite well, if you know where to look. In light of such information, it does not pay to sell your stocks and use that money to pay off low interest rate loans like mortgages. Likewise, if you have money put away in gold or silver, or in land just outside of your city (or even your country), DO NOT succumb to the temptation of selling these investments!
Keep in mind that once money is stuck into a house, that’s exactly where it will stay. Unless you pay money to refinance your house and take cash out, or you obtain a home equity loan (also for a fee), there is no way your house’s equity can be withdrawn. On the other hand, land, gold, stocks, etc., can be liquidated at a much easier and cheaper rate. And you never know when you’ll need an extra $2,000 to pay for junior’s braces, or for that foreclosed property that used to be your neighbor’s house.
As an additional note, investments such as silver, gold, and land have always performed well during bear markets. You protect yourself, and you gain a good interest rate, when you diversify your investment portfolio to include more than just your house and stocks.
- When It Involves Your Dreams.
You cannot sink your entire life’s ambition into simply paying off your mortgage or your car loan. If you desire to go back to school, to start a business, to quit your job and stay home with your kids, then these dreams must become the greater priority in your life. It makes no sense to put off schooling for another 10 years so that you can make a significant dent in your home mortgage. Besides, in those 10 years, had you gone to school, gotten a degree, and then gotten a better job, you would now be earning more money to pay off your mortgage! Likewise, it makes no sense to put off starting a business until you are earning more money- the whole point of a business is to make more money!
As for putting off being a stay at home Dad or Mom, we all know how fast time passes and how fast kids grow up.
Money is important, but so is life. And we have so few good years in which we can live life and enjoy it. While debt can add misery to your life, taking on appropriate debt, like a student loan, enriches your life, and becomes an investment in your future and your greater earning potential.
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