The financial planning community is rightly beating a big anti-debt drum. With nearly 40% of American families having more than $ 15,000 in credit card debt at interest rates above 13%, we clearly have a debt problem in our society. But when one of my non-CFP® professional colleagues recently asked me how someone should prioritize paying off their debt after credit cards are paid off, the emergency fund has been established and one is on. the point of retiring when he wishes, I was not able to give a clear answer.
As in many cases when it comes to our personal finances, it depends. This is one of the reasons I do the job I do – providing people with access to an expert who can help them answer these questions based on their personal circumstances, which research shows. is by far the best way for people to improve their financial well-being. . In an attempt to answer his question about how we reason through these decisions, here are three scenarios from my life where it actually made sense to hold onto debt rather than pay early or upfront.
1. My husband’s student loan. Back when Hubs and I started dating, the conversation turned to finances. (Are you surprised that I was diligent from the start to make sure my future husband was on the same wavelength as me financially?) He said something to me that I literally wrote down in the form of quote: “Taking out a student loan was so liberating for me.”
At the time, he was living at home during his graduate studies. The meals cooked at home were excellent and the lack of rent kept him from having financial difficulties, but he felt he needed to claim his independence and find his own accommodation. He literally said he felt like he was “breaking the chains.”
By moving and creating his own apartment, he gained a sense of independence he didn’t know he missed. His grades improved and he learned to cook, clean, and overall take better care of himself. One of the things I really treasure about him is that he also shares the housework. We cook, clean, wash the dishes and do the laundry. Ours is a true partnership and to some extent I owe it to his taking out a student loan.
Why did it make sense: There are two reasons why this qualifies as “good debt” from a financial standpoint. First, he only took out enough loans to pay his rent and food. Second, he was careful to only accept what he could afford to pay during his first 5 years on the job. He already had a plan in place to pay off debt even before it was incurred, which is the underlying theme of each of these scenarios. Since his grades have gone up, the loan has arguably improved his career options as well.
Where people are in trouble: The problem with student loans occurs when students and their parents accept every dollar offered without worrying about whether the future career will take care of the payment or if the full amount is actually needed. Before signing on this dotted line, make sure you can afford the monthly loan payments after graduation.
2. My car loan at 2%. When I bought a car through a dealership in 2003, I certainly couldn’t afford to pay the whole thing in cash, so financing was a no-brainer, as most people do. when they buy their first car. The dealership offered me a super low rate which allowed me to keep my payment within my budget. But the real decision came 3 years after my 5 year loan, when I paid off my credit card and had to decide what to do with the extra money in my budget. Should I pay off my car faster or increase my savings? I decided to increase my savings and continue to pay for the car according to the terms of the loan.
Why did it make sense: Even though savings accounts always earn less than the 2% my car loan cost me, the goal of my savings was both to avoid higher interest rate debt by having enough cash to dealing with emergencies and investing for the future, where I can reasonably expect to earn more than 2% in the long run.
Where people are in trouble: I’ve heard a lot of people say things like “I just accepted that I will always have a payment for the car”, and that’s like nails on a board to me. A car is not an investment. It is an expense.
Consider purchasing a used vehicle with most of the depreciation paid for by the first owner, but the car still has some warranty. If you can stick with a vehicle until it’s paid off, and then drive it for a few years beyond while making the payment to a separate car savings account, you can get ahead of the game. car payment and open up a new mindset about saving, spending and getting into debt. When I paid for my car, I continued to make car payments, but this time to a car savings account. My goal is to never have a car payment again.
3. Put our new furnace on a credit card equivalent to cash. I hesitate to even include this because to do it right you need pretty strong financial discipline. But a few weeks ago, we learned that our furnace was leaking carbon monoxide and posed a huge risk to our health. We had no choice but to replace it immediately. When the technician presented us with his quote, he told us that Home Depot was offering two years like cash if we financed the furnace on their credit card. We accepted the deal, but only because we knew we would be able to find the money to pay it off at the end of the interest-free period.
Why this makes sense to us: To make this offer work, we added a monthly payment equal to 1/24 of the cost of our furnace to our regular bills and opened a separate savings account where we send the money. This way, when the 2 years (or 24 months) are up, we will have the money on hand to pay off the balance without risking the 22% interest rate on the total balance.
Where people get it wrong: The reason these offers even exist is that credit card companies know people will find it hard to resist spending that money instead of putting it aside. When the 24 months are up, any outstanding balance will not only start accruing interest, but the full 24 months interest is also added to the balance. Ouch! One way to deny this would be to start making payments every month, even if none are due. This way, the balance should be minimal or even paid off when the interest-free period expires.
The bottom line is that when it comes to financial priorities, there are some things that are black and white (retirement always comes before raising children), but there are also a lot of gray areas. A good rule of thumb is to try to keep your total debt payments, including mortgage payments, below 40% of your gross income. It doesn’t matter what the interest rate is if you can’t afford the payment.
Finally, one thing I like to remind people who go into debt to pay for things they couldn’t save for is that if they can find room in their budget for the extra monthly payment, they can find room to save as good. Once a debt is paid off, be strategic with that extra money. Rather than absorbing the payment into your expenses, consider increasing your retirement savings by one percentage point or increasing your automatic savings by the amount of the payment. One of the keys to financial freedom is getting ahead of the things that typically lead to debt like cars, appliances, and even education.