As much as no one enjoys living in debt, the amount of people who can boast that they’re debt free is very few. One could arguably state that about half the American population lives in debt. Now everyone is trying to be debt-free one way or another however wanting to get out of debt and actually being debt-free are two different things. However, have you ever asked yourself is if paying down your best is the best strategy to employ for your money? Well, let me share with you a few situations where paying down debt may not be advisable!
Reason #1: Your loan interest rate is lower than potential investment ROIs
Generally, if your investments generate higher interest returns on your money than the cost of your debts, you should refrain from paying down your debt beyond their minimum payments. For instance, if the interest rate on your mortgage is 5%, and let’s say you find an index fund that is generating a 10% return per year, you’ll come out ahead by investing your extra cash in the index fund.
However, if your debt is at 20%, it’s better to pay down that debt as soon as possible. Although, it has to be said that its investments don’t always provide the same return year over year so this decision to pay off debt or invest will change sometimes even by the day. For example, the index fund that stood at 10% now might drop to a 2% return the following year.
Another factor to keep in mind when weighing this decisions is your risk tolerance. You may or may not be comfortable postponing debt repayments to invest instead given the risks that investing poses. However, if you’re comfortable with the risks that come along with investing and are confident in the investments you’ve chosen then go for it.
So, what types of debts are often postponed to take advantage of better returns in the market? Mortgages and student loans usually tend to charge relatively lower interest rates making them debts that can be pushed to the side. On the contrary, credit card debts are rarely a debt you’ll want to push off.
You should definitely pay off your high-interest credit card debts as quickly as possible. However, you would do well by paying the other debts with low-interest over time. This is so you can take advantage of their cheap financing.
Think about it, why pay off the low-interest debt when you could put that money into an investment instrument that could help clear the debt? Try to consider the possible investment returns. Think about what you could be earning when you successfully invest in, let’s say, the stock market.
That excess cash you wanted to use in paying down that mortgage loan might do you better if you put it to work, considering that mortgage rates are currently very low. There’s little to no comfort in accelerating debt payments because you’ll possibly earn more through investments.
Reason #2: When you must pull from your emergency fund to pay off debt
It is never okay to risk your future in a bid to accelerate debt repayment. Unforeseen circumstances are part of life, and you don’t want to find yourself in poverty when it happens, and for what? Because of debts that can wait?
Unplanned money is as good as debt. Some monies should not be touched unless it’s an emergency and an example of those monies is an emergency fund. You need to plan your cash thoughtfully; after all, it’s hard to earn it. Hence, if you don’t yet have a budget, halt all expenditures until you have one. Keep reading as I will expand on this sooner.
For a long time, budgets have been cast in a bad light however, a conversation with a person who successfully budgets will enlighten you about the freedom and empowerment gained from it. A budget allows you to control your money instead of having your money control you. When you control your money, you’ll make fewer financial mistakes and can guide yourself to reaching all of your financial goals.
Going hand in hand with your newly formed budget is your emergency fund. Experts recommend keeping anywhere from 3–6 months of living expenses set aside for financial emergencies but if you’re more conservative in nature than setting aside a year’s worth isn’t a bad idea.
With your emergency savings always intact, if an unexpected problem occurs, you can sort it without increasing your debt. This way, you’re your own insurance service provider guarding against further debt. Likewise, your present debt should not be the reason you can’t continue providing this service for yourself, as that only means more incoming debts. And then you should know that going into debt due to an emergency means whatever interest rate gets thrown at you, you’ll probably take. Hence you end up in more debt than before.
Reason #3: When you have zero-interest debts
Believe it or not, there is such thing as a zero-interest debt and if you currently possess them then paying them off as soon as possible may not be advisable. So first, what are some example of zero-interest debt. One example are promotional debts that offer zero-interest periods. Examples include promotional credit cards that have zero interest for 12 to 18 months or longer depending on the deal that’s being offered. Another example are loans from family or friends. In both situations, you obviously must pay back these loans but prioritizing their repayments may not be advisable again due to the opportunity cost you’re incurring.
For instance, you would never invest in an asset with zero return when you could invest in another asset that offers a 10% return, so why would you pay off a debt with no interest attached to it? Now, I will admit that some zero-interest debts will still prompt you to pay them back sooner than financially you should and this particularly relates to when you are borrowing from family. You may despise owing a family member money as they may hold that money over you or it may cause a ripple in the relationship and if this is the case then paying off that said may be the best move you can make. Otherwise, leverage all the zero-interest debt you can feasibly manage and only pay it off when that zero-interest period is about to expire!
Reason #4: when your debts are giving you tax breaks
Tax breaks are beautiful things as it means the government is offering you a reduction in taxes. Tax breaks come in different forms, including the exclusion of income from tax returns or claiming deductions. In certain instances, tax breaks may not require any actions on your part. This is usually the case when you get a reduction on your income tax rate or an increased value of the exemptions available to you. Simply put, the right time to pay down debt is when you’re not putting yourself at risk of getting into another possibly bigger debt. This is one of those situations.
By now, I believe you’re familiar with the types of tax breaks that are most common. You get those yearly when you receive deductions which decrease how much is taxed from your income. The government is not mandated to offer these; however, when they do, it’s like Santa Claus coming to town as they present you with a tax break.
The federal government has been for ages allowing people to claim differing itemized tax deductions. This effectively offers you more in tax savings. As a result, there are organizations that provide people with debts with tax breaks. There is no reason to hasten to pay off debts when the opportunity to invest successfully presents itself.
Generally, certain types of tax breaks, such as income exclusion, apply to a particular group of taxpayers — obviously, this for those who are proper and consistent with their tax payment.
Some tax breaks are designed to reduce your tax debt as opposed to simply reducing how much is taxable from your income. Whatever the tax break, you get to have less money going-away, and that is reason enough not to accelerate your debt payoff. However, it must be said again that your risk tolerance when it comes to not only your investing approach but your comfortability with how much debt you’re carrying cannot be overlooked. I think I should say once again for emphasis’ sake that if you can possibly get an income exclusion or tax break, you should invest that extra money. The point is not to rush off to clear a debt that’s not destructive when the money can be used to bring in more money.
Reason #5: When you must pull from retirement accounts to pay off debt
In a situation where you have many credit card debts with a high-interest rate, people usually hasten to liquidate their assets to pay off the debts. However, before you empty your retirement accounts, there are things you need to understand first. Would I advise you to withdraw from your retirement accounts early? My short answer is a capital NO! For a more elaborate answer, keep reading!
Even when the interest rates on your credit card are higher than the tax rate, it’s basically never a smart move to withdraw from your retirement accounts early. To further bolster my point, I’ll show you the kinds of retirement accounts available. Also, I will detail the costs you’ll attract when you withdraw before retirement.
Prior to checking the repercussions of emptying your retirement account because of debts, it’s pertinent to grasp the differences in Roth and traditional accounts. The accounts are handled differently due to early distribution. A regular retirement account gets funded with pre-tax dollars. Earnings and contributions get taxed during distribution. A Roth retirement account, on the other hand, is funded with after-tax money. Earnings and contributions, however, get distributed tax-free. Also, you should consider the differences in the two main kinds of retirement accounts which are IRA and 401(k).
An Individual Retirement Arrangement (IRA) is not sponsored by an employer. This is an account you sign-up for by yourself and select how it will be funded. Both the Roth and Traditional options are available for this account.
Meanwhile, a 401(k) account is a plan that’s sponsored by the employer. It is, therefore, a method of funding that gets decided by your employer. It’s likely you’re on a 401(k) plan if the contributions are automatically deducted from your paycheck. However, a lot of employers offer the Roth option.
Typically, a retirement account may be distributed until after 59½ of age. Hence withdrawing early, means you’ll possibly have to pay penalties and taxes. You also risk losing out on investments’ biggest benefit, which is future gains.
Again, early withdrawals from your IRA or 401(k) could mean you have to pay taxes. With a Roth account, the taxes are automatically paid, so there’s no fear on that end. Now, just as I said earlier in this video, retirement funds are designed to remain in the account till retirement. Thus, you deciding to withdraw before 59½ may attract a penalty.
In conclusion, debt can be a hindrance on your financial progression but sometimes it just doesn’t make sense to prioritize them over other financial responsibilities!