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Debt,Financial Planning

How Aggressive Should I Be At Paying Down Debt?

There are certain sequential steps in cash flow planning that most financial planners can agree on, which are usually some variation of Dave Ramsey’s Baby Steps to Financial Peace.  But after the first few steps of paying off credit cards, setting aside an emergency fund, and contributing to your 401(k), there can be some gray area as far as the best next step to take.  There are many options of how to use your savings, so how do you make the best choice?  In particular, is it a better move to add to your investments for retirement or college funding, or to become more aggressive at paying off any other debt including your mortgage?

Guaranteed Rates of Return

Savers are continuing to get punished with very low interest rates.  Most checking accounts are paying somewhere around 0.01% interest, so low that I’m tempted to tell the bank to just not bother.  The benefit to a bank account is that there are guarantees that our funds will not lose money and so we accept a lower rate of return. 

But there is another option of guaranteed rates of return in the form of debt pre-payment.  Paying down debt will earn you a guaranteed rate of return on your cash of whatever interest rate is associated with that debt.  If you have a mortgage with a 4% interest rate, paying that down ahead of schedule means you are essentially earning a guaranteed rate of return of 4% on those funds, 400x the rate of return of my checking account. 

In addition to the financial considerations, there are spiritual ones as well.  Proverbs 22:7 warns that “The rich rule over the poor, and the borrower is servant to the lender”.  Romans 13:8 encourages us to “Let no debt remain outstanding, except our continual debt to love one another”.  While the Bible doesn’t prohibit the use of debt, it certainly cautions us regarding its dangers. 

Potentially Higher Rates of Return

The other primary option you have is to invest the funds to try to earn a higher rate of return.  Because debt is relatively cheap right now, chances are you could earn more money by investing in a diverse portfolio of stocks.  Given enough time, this will likely be the case, but as 2007-2008 evidenced, this is far from a guaranteed thing.

If you have an extra $1,000 in your checking account and earn 0.01% for the next 20 years, you would only end up with $1,002.  If you put it towards your mortgage with a 4% interest rate, you would end up with $2,191 (in more principal paid on the loan) with no additional volatility risk.  If you had invested in stocks and earned 8% per year, you would end up with $4,661.  But you could have also seen your funds drop to $600 by the end of the first year.      

Which is the best strategy to take?  If you are behind in saving for retirement, then aggressively saving for retirement is likely the best place to start.  If you are a bit ahead of schedule, then prudence would suggest to begin eliminating all debt, including your mortgage.  If you aren’t sure which of those two categories you fall into, let us know and we can help you determine the answer.