Paying more than the minimum amount due on an installment loan, like an automobile loan or a mortgage, saves on interest expenses in the long run. You owe the money for less time, and hence pay less interest. There are of course lots of ways to pay down loans more quickly. There's something for everybody who wants to be debt-free. We're planning to pay down our debts faster after getting a decent emergency fund.
The flip side of paying off debts faster than required by the lender agreement, though, is that the extra money paid toward the debts are then unavailable for other use. The extra money pays down the balance faster, but you can't take it out after you've done that (at least not easily).
However, what if you see leaner times in your future? That's what many federal employees are looking at now that sequestration has gone into effect. Furloughs are a little over a month away for many. For some of the hardest hit, it could amount to more than two full biweekly paychecks. This is thousands of dollars.
When looking at this loss of income, there is an easy way to save more if you're already on an accelerated debt repayment plan. That's simply to go back to paying the minimum on those loans until things get better.
Paying just the minimum on debts does make them stick around longer. That's the cost. But it does accomplish two things:
- It still keeps creditors happy. In fact, it probably will make them happier! The payments are still coming in, on time. They're being paid what they require: the minimum. They're extracting the maximum amount of interest out of you again. Your credit rating will stay where it is, or improve.
- It decreases expenses. Less money going out to debt means more money in the checking account. If you actually have a *need* for the money — as you might during a time of partial layoff — it will be good to have it there.
Now, it certainly is far preferable to cut other areas of consumption first in order to re-normalize the budget — like postponing vacations, eating out less, or doing a targeted no-spend month. If doing these things, and other things, gets you where you need to be with the smaller budget, then there's no need to pay down debts any slower than you are.
But if the months are just a bit too long for the smaller paychecks, then dialing down the rate at which you're paying down debt — temporarily — can help. It will reduce the chance that you'll need to take on more debt during the lean times.
Well, some will argue that it’s not the best idea compared to other options, but I think paying down debt is never a bad idea if you have the money available to do so, and paying it down won’t lead to having to turn around and take on more debt. Many will argue that paying down a low rate loan doesn’t make sense compared to an investment opportunity, and again, while that can be true, if someone chose to pay down debt instead, there’s nothing wrong with that decision.
It is simple, you should always opportunity costs. If your student loan had an interest rate of 3% and you could could get a reasonably receives a higher return, you should. If you concentrate on paying off your loans in your 20s, you miss out on 8 years of your 401K. Those years are extremely important.
Very true. It’s tough to make up for lost time at the beginning.
John, I often think of this. I have student loans that I will have to start paying in around 9 months. Right now I make enough money not to take out any more and use my extra income to invest. I have been making higher returns than what my interest rate will be so I have decided to put them off until later this year and probably split my money between investments and loan payments. I must admit I revisit this question with myself on a quite frequent basis.
That’s great! Beating your loan rate with investment rate actually is pretty difficult to do, I think.
Maybe if you get more money than usual in one month you can use that extra money to pay off the debt.
Sure! Bonanzas are great for debt reduction. It’s a wise use of them.
Well, John, I agree with you, and the math agrees. But there’s a vocal group that talks about emotions, and motivation. To the extreme, they’ll choose to pay their debt to zero even before depositing to their 401(k) up to the matched deposits.
We are at a very odd time in the interest rate and investing cycle. When my mortgage is 3.5% and post tax 2.5%, I have to ask myself, would I rather knock it down faster or use the extra funds to continue dollar cost averaging into the market?
Last, you are right about liquidity. Pay the mortgage in full, lose your job, and no one is looking to lend you money. I’d prefer the fat emergency and retirement accounts than a zero mortgage balance.
Joe, 3.5% is phenomenal. Even if it’s against your primary residence, that’s practically an asset if it’s fixed rate (which I assume it is).
Another way to deal with the unknown of a potential job loss (assuming you’re still in a job right now) is to review your federal tax withholding. I just did this for my family. We have a household income of about $130k a year, and routinely get around $8k back in federal tax refunds each year.
So instead of giving that money to the government, we adjusted our withholdings, which nets us about an extra $400 or so a month and still allows us to have a bit of a “windfall” at tax time (but a few thousand rather than over $8k).
I think paying off debt as fast as possible is important but not the sole reason to live. If you don’t have the extra money for a month, or see that furlough coming, I agree that paying the minimum is the best. I’m anxious to pay off my mortgage, but not to the extent that I’m left with no money for retirement savings and emergency fund.
You are absolutely right that paying off debt slower is better than having to add to it when your income drops. By the same reasoning, pay that debt off asap when times are good!