Demystifying Debt: Why Quickly Paying Off Debt May Be a Bad Idea
If your family is anything like mine, growing up debt was a big no-no in a stable, upper-middle-class existence. My parents had never borrowed money to go to college, they had bought our cars with cash, and they got their first credit card within a year of me doing the same. Not borrowing money, or if you did, paying it off as quickly as possible, was the “respectable” and financially smart thing to do. Debt was seen as a burden, not as the tool it actually is.
Why should (and shouldn’t!) we borrow money?
In 2019, 69% of students took out student loans, and the after graduate walked off campus with $29,000 of student loan debt. Additionally, the average American has about $6,000 of credit card debt, meaning that for most Millennials, debt has just become an accepted part of our lives.
While this is a huge stressor for many people, debt isn’t necessarily a bad thing. Borrowing to improve your earning potential via education or to invest in a business idea can actually improve your overall net worth over the long run. The key here is that “right” borrowing is borrowing that increases your potential to earn future income. This is the difference between borrowing to spend, versus borrowing to invest.
How to borrow the “right” way.
Whenever you borrow money, it’s important to take a realistic and analytical view on 1) how much your earnings will increase as a result of this borrowing and 2) how quickly you’ll be able to pay the debt back with those incremental earnings only.
For example, let’s say you want to borrow $5,000 to take a course that will allow you to get a new professional certification. You’ve had a conversation with your boss, and you know that this certification could increase your ability to serve your clients and thus your future earnings potential for the firm. You’re confident this could result in a promotion within a year of you getting the certificate which would increase your salary by $10,000. In this case, 6 months of breakeven ($5,000 cost / $10,000 salary increase per year = 0.5 years breakeven salary before the loan pays off) seems like a fair trade and overall a good investment. Of course this doesn’t include interest payments, but given the timeline we’d assume these to be de minimus.
Student loans are the obvious place where this analysis rarely happens, often because we’re too young to be equipped with that information. Before you borrow to study, do some work on how much money you’d earn without the degree, versus what the average salary is of people with the degree you’re pursuing. Is what you’re studying worth borrowing money? Not all degrees are created equally.
How to pay off loans the “right” way.
There is a balance to be struck between paying off debt and investing, and rushing to pay off debt is not always the best approach. Public student loans (i.e. Sallie Mae) in particular have some of the lowest interest rates you’ll be able to borrow at in your life. If you can take out a student loan at 4%, but the stock market is earning 7%, you’re better off investing everything except your minimum payment and earning a difference of 3% on that amount.
Here’s how to decide what to pay off first:
- Always pay the minimum on all debt accounts first.
- Then pay off as much as you can on “expensive” debt, like credit cards. Anything with an interest rate higher than 6–7% falls into this category (you can check your interest rate in your student loan statements or credit card statements).
- If you have multiple sources of “expensive” debt, figure out the interest rates on each. Always pay the high interest rate loan first after you make the minimum payment on all loans. Do not pay off the loan with the lowest / highest remaining balance — this is largely irrelevant in terms of wealth and credit building! Note that private student loans are more expensive than public student loans like Sallie Mae, so if you have loans from multiple providers, check the interest rates.
- Once you pay off expensive debt (i.e. if your remaining debt all has an interest rate of below 6–7%), it’s time to speak to a financial advisor. At this point, it may make sense to invest your “extra” money each month into the stock market instead of focusing on debt repayment. There are of course considerations on your credit score, future ability to repay (i.e. if you are about to take a career break, you may want to pre-pay debt to cover future payments). A financial advisor should be able to help you at this stage.
Not all debt is bad debt! Understand that interest rates (a percent outflow) must be compared against stock market returns (a percent inflow) to decide how to use your money and whether it’s better to pay off debt or to invest. For more on Empowered Investing, join FeministFinance on Instagram or join us at one of our upcoming workshops.