Save your money or pay off debts? It probably comes as no surprise to hear that it depends. But one thing is certain: paying off debt is not the same as saving. Here’s why. Calculating your net worth is simple: total up the value of everything you own, and subtract all of your debt from that.
Net Worth = Assets – Debt
If you look carefully at the formula for net worth, it’s clear that paying off debt doesn’t immediately increase your net worth, because it reduces your assets by as much as it reduces your debt. So by itself, paying off debt doesn’t do anything to advance your goal of building your wealth. It only helps if you save the amount you are no longer sending to your creditor.
Higher Priorities Should Come First
Paying off debt can also make your financial situation more precarious. For example, if you deplete your savings, you may be in a worse position to cover your expenses in the event of an emergency. In fact, it’s one of the principles of good planning to maintain an emergency account equal in value to your living expenses for three to six months. So unless you already have enough tucked away in your emergency fund, you should think twice about using any free cash to pay off a debt. And if you have a spouse and dependent children, maintaining a life insurance policy sufficient to meet their needs should also be a higher priority than paying off debt.
But let’s say you have both of these objectives covered. Does it make sense to be aggressive in paying off your debts? It can. It generally comes down to comparing the potential return on your investing choices to the effective interest rates you’re being charged on your loan.
Compare interest rates.
If you’re paying a higher rate of interest on a debt than you could earn on an investment, it makes sense to pay off that debt as quickly as you can. Such is typically the case with credit cards. Making only the minimum required payment is generally a bad idea, because interest and fees can grow faster than you pay down the principal. At the very least, you should try to pay more than the minimum.
If you have money left over at the end of the month, you should consider both trying to save and paying down your debt at the same time. This is especially true when it comes to tax-advantaged savings plans. Contributions to these are often made on a pretax basis, which adds to the effective total return you receive. If your employer matches your contributions, you should do all you can to contribute to the maximum match.
Don’t forget the power of compounding.
The biggest reason to save and pay down debt at the same time is that saving even relatively small amounts puts time on your side by harnessing the power of compounding. When you reinvest your returns, your money makes more money, and you can reach your long-term goals faster.
Be careful about paying off mortgages.
Owning a home free of mortgage debt remains a fond dream that influences the decisions many Americans make. However, it’s not necessarily a smart idea to take out a 15-year mortgage, because the required monthly payments are generally 20% to 30% higher than the payment on the same principal amount for a 30-year loan. That means you’ll have less free cash flow to devote to saving in a retirement plan; and if you lose your income for an extended period of time, it’s harder to keep up with the payments.
Mortgage interest is also generally tax deductible. Finally, the interest rates on mortgages are among the lowest consumers face. All of this means paying off a mortgage more aggressively is one of the last things you should consider doing with your money.
Please call if you’d like to discuss this in more detail.
Copyright © Integrated Concepts 2015. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.