Paying Off Debt: A Guaranteed Return
If I offered you an investment with a guaranteed return of 15%, would you invest? Honestly, I hope you initially said "no" because you should be suspicious. Suspicions aside, my guess is that you would figure out a way to invest as much as possible in this investment opportunity. Who could resist? This is a higher return that what the S&P 500 averages (abot 10% per year), and you have to handle a lot of risk to get that return.
Here's the thing, though, if you have any debt, paying off that debt is the same thing as getting a return on an investment equal to your interest rate.
Believe it or not, getting paid interest and not having to pay interest are the same thing.
Debt has many meanings, so let's explore some of the ways in which we owe money.
Credit Cards
Some of us have credit card debt. The average credit card interest rate is north of 15%. Paying off that debt will earn you 15% because you won't have to pay that interest anymore. This is among the easiest decisions for us; even most who aren't in the personal finance industry would agree that paying off credit card debt is a good investment. What about some other debts that aren't so obvious?
Car Loans
What about car loans? Car loans have lower interest rates (typically) than credit cards. Wouldn't you be better off keeping the car loan and investing any excess money in the stock market?
Yes and no. This, like so many topics in personal finance, comes down to your comfort level. Just because there are people who would prefer to invest rather than pay off a car loan does NOT mean it's right for everyone. I want to make sure you have enough information to make an informed decision.
Many assets we buy we expect to go up in value. Think about houses, investments, antiques, and so on. Assets that are expected to go up in value are called appreciating assets - they are expected to appreciate. There are other assets we buy that we know will go down in value, including cars. There are many situations where it makes sense to take out a car loan, but an investment isn't one of them. Consider this, by taking out a car loan we are effectively borrowing money to buy something we know will go down in value. A better plan is to save for the car - think of it like a car payment to yourself. This way to earn interest instead of pay it.
Besides, after you pay off a car loan, you will have more cash flow that you can invest if you want to. Paying off a car loan, no matter the interest rate, is a guaranteed return.
Mortgage
There are many people who think they "need" to have a mortgage because they get a mortgage interest deduction on their taxes. You wouldn't believe how common this worldview is. I had a client in the past who had more money than any of us can imagine, and he wanted advice on how to get a mortgage on his house (which was paid for) so that he could write off the interest. If you hold this view you are not alone.
Let me explain why this doesn't make sense. Let's assume you are in the 25% tax bracket and you pay $1 in mortgage interest for the year. You get to deduct that from your income when you file your taxes. So if you made $100 last year, and you deduct your $1 interest, you pay taxes on $99. You will owe $24.75 in taxes (99 x 0.25). So your net income is $74.25 (100 - 1 - 24.75). If you didn't have a mortgage you would pay more taxes, $25, but you wouldn't have paid any interest. So your net income would be $75 - 75 cents higher than when you had a mortgage. This doesn't even consider the fact that your cash flow is higher without a mortgage.
So the bottom line is that we shouldn't pay $1 to get $0.25 back. If your mortgage rate is 4%, paying off your mortgage is a guaranteed 4% return.
Student Loans
The argument for keeping these around is similar to mortgages. We get to deduct the interest from our income on our taxes - and we don't even have to itemize our deductions in order to do it! But, the same argument applies as above. Don't pay $1 to get $0.25.
You might often hear that student loans are "good" debt, as opposed to "bad" debt. That may be true in the sense that we can borrow money to get an education and increase our earnings potential. But that's the reason to borrow, not the reason to keep the debt around. Any interest you pay is money you can't save for your goals.
It's the same story - if you have a student loan at 6%, paying it off is a guaranteed 6% return.
Conclusion
I'm sure you can think of other types of debt, but the same rule applies to all of them. Paying off your debts is a guaranteed rate of return.
