Using Debt to Find A Pot of Gold!
It shouldn’t be a surprise to anyone that interest rates are at historical lows. So, paying off certain types of low interest debt, is like throwing away free money. That same cash can be invested in a portfolio instead. A simple analogy is paying 3% on debt vs 9% of growth in the S&P 500. For every dollar you put in the S&P, you net 6%. Now, extrapolate that over 15 or 30 years, and we are talking a major difference for you financially! If you manage to get that extra 6% growth in a Roth, tax-free, then you just found a pot of gold at the end of the rainbow.
Now, let’s look at types of debt.
Let’s say your mortgage is $300,000 at 3% for 30 years. Your principal and interest payment will be $1,264. Interest paid over the life of the loan will be just over $155,000. While that might be hard to stomach, hang in there, I’ll explain some tradeoffs.
If you refinance to a 15-year term with the same $300,000, your payment will jump to $2,071, an increase of $800 per month. Interest paid over the life of the loan is over $72,000. That is a savings of $83,000 of interest, but not so fast! If, instead of refinancing, you invest the difference in payment of $800 per month in the S&P 500, netting the 6% difference, you will have $230,000. If you are someone that can’t sleep at night over debt, pay it off and get some rest. I like the sound of $230,000.
Let’s say you use a portion of the $800 to contribute $500 per month to max out your Roth IRA for the year. After 15 years, you will have a balance of $144k, with $50k of tax-free growth!
Your loan type and interest rate play a role in the decision to pay it off or not. It goes without saying - the higher interest rate loans make sense to pay off earlier. Private student loan interest rates can sometimes be lower than federal rates, but approval for the lowest rates requires excellent credit. If you have good credit, you may be able to refinance existing student loans to get a lower rate and save your cash to grow your nest egg or retirement accounts.
Not all credit cards are bad. In fact, there are lots of reasons to use credit cards. The points, the fraud protection, the ability to pay when the statement is due, building credit, lots of things. But to take advantage of these benefits, you must pay the statement balance, each month. If you don’t, then you will owe interest, and interest rates on credit cards aren’t attractive. Credit card debt is rarely a good thing, with few tradeoffs to maintaining it, so you should probably pay it off.