The other day someone was talking with me about their urge to pay off all of their debt. We had a long discussion about it, and they were making decisions based solely on the beliefs on building assets vs. paying down debt. They weren’t taking into account the actual numbers. There is nothing wrong with that – we need to be able to sleep at night! However, talking a little about their specific situation made them feel more comfortable with considering their options and what supported their goals most.
I completely understand the pressure to be debt free as soon as possible. First, how fun would it be to say “I’m not in debt to anyone or any institution!” Also, having fewer debt payments each month means there is more discretionary income to put towards what you want to be, have, and do, most!
However, there is an argument against accelerating to being debt free right now. Interest rates have been historically low! Debt we have at 0% (which wasn’t probably 0% when we took it out) or even 2.6% is unbelievably low when we compare what typical market returns are at 8-10%.
So, I want to talk about the arguments for and against accelerating debt payments vs. building assets while paying down debt slower.
Ground Rules to Know About Working Towards Being Debt Free
1. Carrying Credit Card Debt is Very Expensive.
The average interest rate on a credit card was 16.45% in 2021, and it is not unheard of for credit card interest rates to be as high as 25% or 30%. Carrying credit card debt is very expensive.
At MPower Co, we believe credit cards can be very valuable for fraud protection, earning rewards for spending, and more.
We understand that life happens, and sometimes we need to rely upon credit cards for emergencies if we don’t have adequate emergency savings. In fact, 56% of Americans don’t have over $1,000 in emergency savings.
When deciding to pay down debt or to build assets, if you are carrying credit card debt from month to month, it almost always makes sense to accelerate paying down the debt over building assets.
2. Don’t Walk Away from Free Money.
On the flip side, when thinking about building assets: if there is an opportunity for free money, don’t walk away from it! If your company offers a match within a sponsored retirement plan (i.e. 401k, 403b, etc.), it is beneficial to pay into the plan in order to capture all of the match.
Companies have a wide array of ways for defining the rules for participation, so review your specific plan. Getting a 3%, 4%, 5%, etc. match on contributing to retirement, is like giving yourself a raise without having to do additional work!
So, even if you are carrying credit card debt, do the bare minimum to get the match from your employer. Then create a spending plan that pays down your credit card debt with any discretionary income.
3. Know the Interest Rates of Your Debt
After credit card debt, interest rates on debt can vary significantly. Student loan interest rates vary widely between federal student loans and privately held student loans. Mortgage rates and car loan interest rates can vary widely.
To make things even more tricky, some debts have variable interest rates (i.e. a balloon loan, that is 0% for a period of time and then goes to a different, typically significant interest rate). Think about credit cards that offer 0% for six months and then jump to 26%. It is critical to know the interest rates on all of your debts and how they may change over time.
Take time to review all of your debts and put together a spreadsheet of your debts and their current interest rates and any anticipated changes. Without having this accurate information, you cannot make a truly informed decision.
4. Research the Anticipated Return of the Assets You are Considering.
This is tough because in the investment world a guaranteed return is a red flag and historical performance is not a guarantee of how something will return in the future. If someone is telling you the opposite of these things, you need to ask a lot of questions. However, we aren’t going to build wealth without investing. There are also a lot of different types of investments: index funds, mutual funds, exchange traded funds, private placements, real estate investing, etc.
However, you have to go with something, right. So, doing research and knowing the historical market rates, can give you information that can give you a kind of ballpark for your goals when building assets.
5. Always Make Minimum Payments.
No matter your overall goal, it is important to, at a minimum, make the minimum payment on all debts. Failing to do so will affect how your debts are reported and therefore your credit score. This means if you do need to take on new debt because life happened, your interest rates will be higher.
Failing to make minimum payments can also affect the interest rate on that debt. Failing to make minimum payments gives some lenders the ability to raise your interest rates. The goal is to pay as little interest as possible.
6. The Source of Funds Matters.
When considering whether to pay down debt or build assets, it’s very important to think about the source of funds you are using to pay down the debt. The most likely source of funds is discretionary income.
However, there are sources of income that we may have access to. MPower Co highly encourages you not to access other sources of money, unless that was what the source of money was for.
For instance, emergency funds. If you wake up one day and decide to use all of your emergency funds to pay off your car debt, what happens when you have an emergency car or home repair and don’t have funds sitting there?
Accessing funds in a retirement account is usually not a good choice. Dr. Thia, MPower Co’s Director of Education would highly caution you from accessing funds invested for retirement. Not only are the gains taxable, but there can be penalties and fees for accessing funds in a qualified retirement account. There is also a loss of time for those funds to compound by retirement.
Accessing cash value on a whole life insurance policy is likely not a great option to pay down debt, because the value of funds accessed accrues interest and needs to be paid back for the full policy to be in force.
Also, if you use assets that accrued in an investment account to pay down debt, there may be a taxable event (i.e. short term or long term) if there were gains on the investments. It’s typically best to liquidate positions with a loss first for tax reasons.
The goal is to pay down debt in a sustainable way, so that if life happens you are still ok and don’t have to take on new debt. That is really the trick of becoming debt free – paying off debt and not taking out new debt.
Frameworks for Choosing to Pay off Debt vs. Building Assets
So, now that we have all of that information under our belts, how do we really decide if paying down debt is more effective or if building assets is.
1. Focus Solely on the Numbers – Time Value of Money.
If all of your debt is at a rate of 0% when you put together the interest rates, it likely makes sense to make the minimum payments and then use the discretionary funds you have to build assets that support your goals (i.e. invest for retirement, invest for kids education, etc.). Even if your debt is at 2% or 3%, that still may make sense.
If your debt is at 10%, 12%, or 16-30%, it likely makes sense to pay down debt vs. using discretionary funds to build assets. At that point, the amount you are making building assets is negative to the amount of interest that is growing. So, you aren’t building wealth – you are just working really hard to even break even. The goal is to build wealth.
However, it’s when interest is in the 5%-10%, it likely is a tradeoff. The growth in assets is likely around the amount of interest that is growing. So, take into consideration my next point:
2. What pays for your goals first?
Take a minute or a couple of days to think about what it is you want most.
If your biggest overarching goal is to be debt free, it makes sense to focus on paying down debt at a quicker speed than the minimum payments. If you have short-term or long-term goals that you know you need to focus on building up funds for, focus on building those assets.
Remember, it doesn’t have to be an either/or situation. It can be both! When I was talking with this person about their goals to be debt free, they also had some assets they really wanted to work on building. Reminding them that they could accelerate paying down debt and also building assets at the same time by splitting their discretionary funds was a turning point for them.
Being so focused on one thing – being debt free is great. But if paying down debt doesn’t help you focus on the things you want to have, and do, you’re likely going to be in a situation where you need to take out additional debt. So, it’s important to live for the present but also be thinking about the future as well.
3. What will improve your ability to sleep at night?
I know someone who recently came into some wealth. Their biggest goal was to pay off their home. The wealth they came into would do that. Their mortgage was at about 2.8%. They knew it may have been smarter to put the money into an investment and build another asset; however, they were really attached to the fact that what they wanted most was to pay off their home with those funds. I cheered them on all the way to the bank!
They were thoughtful, and made a decision that owning their home would help them sleep better at night. Now they have more discretionary income each month, and they’re now able to focus their efforts on their next goal(s) because they have owning their home outright under their belt.
It’s important to take this into account. If carrying debt, even if it is at a low interest rate, creates an emotional response for you, focusing on that debt is worthwhile. This can certainly come into play if you have personal debts to others as well!
Likewise, if your debt is at low interest rate(s) and you are confident in carrying that debt and your focus is building assets, and you can sleep at night doing that, go for it. We are living at a time where this is possible. Interest rates are historically low, so taking advantage of that, if you can be disciplined, could pay off.
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