Here's an email I recently received from a reader:
Is paying off low-interest debt always the best choice?
I am very fortunate in that I only have one source of debt: a car loan. No student loans, nothing on my credit cards, nada. My interest rate for my car is about 2.8% over 5 years (I'm 1.5 years into it).
My plan had been, once I got to July 2013, to switch my emergency fund savings to paying double on my car payment, to kill the debt faster. I thought that was a good idea, and everything I read seemed to suggest it was. But then I read an alternate view in a book sample I downloaded for my Kindle. That author suggested that if your interest rate is less than 3%, you are better off investing your extra money rather than putting it toward your debt. (I'm sorry I can't remember the book, the title had to do with finances in your 20s and 30s; I deleted the sample as I didn't find it very helpful, but the above idea stuck in my head.)
What do your readers think? Should I double up on my payments to destroy the car debt? Or should I funnel the money into my IRA? Right now I'm not quite yet at the point of making regular payments to my IRA: I am saving up for two more mutual funds (a bond fund and an international stock fund; right now everything is in domestic stocks, and I know I need to diversify). If I diverted that extra $220 to the IRA, I could reach my investment goals a lot faster, and I know time is money (as a reminder, I'm 26). But of course, debt is slavery, and I'd love to get rid of that car debt sooner, plus save on interest.
I'd love to hear your opinions!
What's your advice on this subject?
Personally we've paid off all of our debt, including the mortgage. My recommendation to others would be to do the same. Being free from debt payments gives us more options for the use of our income.
In the summer of 2006, we sold an investment asset (commercial real estate) for a nice profit. The proceeds were enough to pay off our home mortgage. We debated for several months whether to pay off the mortgage or invest the proceeds. Finally, in December 2006 we decided to payoff the mortgage. In 2007/2008 the financial crisis hit and had we invested in the market, we would have lost half the money and still have our mortgage. Fortunately (luck? divine intervention?)we made the right decision. Of course I can't predict the future - maybe the markets will continue to climb as they have for the last year. Maybe they'll drop by 50% again very soon. Who knows?
The peace of mind of having the debt gone has value (at least to me), although there is no way to quantify it. Don't leave risk out of your analysis.
Good luck.
Posted by: J A M | July 20, 2013 at 07:34 AM
"But of course, debt is slavery, and I'd love to get rid of that car debt sooner, plus save on interest."
If you're interested in wealth-building, I'd recommend ditching your current education on these issues. First of all, some debt is very beneficial for building wealth (that would be, debt on appreciating or income-producing assets, which helps to stretch your investment dollar). Second, "saving on interest" is only effective if it puts more money in your pocket, right? So if, in fact, you can make more money by investing than you can by paying off your debt, which choice actually saves money?
Personally I'd recommend you start investing post-haste and get an education in wealth-building, since that sounds like a goal of yours. Check out FMF's other site (Wealth Lion) for more advanced discussions on these topics.
And to answer your opening question - "Is paying off low-interest debt always the best choice?" - No, and in many cases it's the wrong choice.
Posted by: Jonathan | July 20, 2013 at 10:37 AM
@Johathan
"Is paying off low-interest debt always the best choice?"
A clearer answer would be can you make more in interest with that money than the 2.8%. I think you can.
The problem comes about when you have a stack of money only making 1% and debt taking 2.8% from you.
So the question to you is can you take that extra money and invest it to make more money than the 2.85 it is costing you?
Posted by: Matt | July 20, 2013 at 01:34 PM
Due to manipulation by the Federal Reserve, actual inflation is higher than the interest you are paying on your car loan (although the official government numbers suggest that your car loan interest rate is slightly above inflation...they do have an incentive to understate).
I suggest paying your car loan off as slowly as you possibly can. Then, with the extra money, pre-buy as much stuff as you possibly can before inflation causes prices to increase. Stock up on things like toothpaste, paper towel, boxed/canned foods, etc. Anything that you plan on using anyway that can be stored without going bad/expiring. When the prices of those items do go up in the future and you eventually consume them, you avoid 100% of the income taxes that would be otherwise classified as "capital gains."
Assuming you have extra money left over, put the rest into gold or silver coins. Right now, it's cheaper to buy gold on the open market than it is to produce it. That is something that happens almost NEVER.
Posted by: Tommy Z | July 21, 2013 at 10:11 AM
"it's cheaper to buy gold on the open market than it is to produce it"
Gold is trading over $1200 and it cost $900-$1100 to mine it.
ref:
http://www.businessinsider.com/cost-mining-gold-infographic-2013-6
Posted by: jim | July 22, 2013 at 01:45 AM
Mathematically speaking, you can do better by investing instead of paying off the debt. There is, however, risk involved with this strategy. Speaking from personal experience, we have zero debt (yes, we paid off a relatively low rate mortgage) and we have no regrets.
Posted by: Michael | July 22, 2013 at 10:06 AM
With the car loan as the only debt, and given the asker's young age and picture provided, I would recommend putting more into savings over doubling down on the car loan.
That said, to me it's about risk. The longer you have a debt attached to collateral, the greater the risk if things go bad that you can lose that collateral. A car, over 5 years, may be low risk and low overall impact to someone's life picture. A house over 30 years is greater risk.
Posted by: getagrip | July 22, 2013 at 10:16 AM
If you direct your energies towards paying off the debt, you will find ways of freeing up more money to accelerate the repayment. Once the car is paid off, you will find that your mentality changes even more to be debt averse.
Posted by: JimL | July 22, 2013 at 10:26 AM
I agree with JimL and vote for paying off the car loan first (while becoming more a educated investor in the mean time). There are added costs of having a car loan, including that you generally have to cary more expensive insurance.
Posted by: BH | July 22, 2013 at 12:34 PM
I would highly recommend eliminating the debt.
I don't like any form of debt, that financial four letter word. Get rid of it.
No math will every outweigh the psychological impact of living a debt-free life as far as I'm concerned.
Posted by: No Waste | July 22, 2013 at 05:05 PM
Do not accept debt for a depreciating asset. Sell the car. Use the proceeds to pay off the loan and buy a reliable used car that is 5+ years old. Pump your new-found cash flow into your investments. Profit.
Posted by: Freedom Fighter | July 23, 2013 at 10:12 AM
Freedom Fighter, if he is paying $220 a month for 60 months, it probably is a used liable car. Unless he put a huge down payment (maybe he did), selling that car is not going to pay off his loan and buy an actual reliable vehicle outright.
If I were him, I would just put the extra money in a savings account and once he has enough to pay off the remaining balance, do it, and if something comes up along the way, he has an emergency fund.
Posted by: uncle snake | July 23, 2013 at 10:49 AM
@uncle snake:
I estimate the total amount financed to be approximately $12,300 based on the interest rate and payments. At 1.5 years in, the amount remaining should be about $8,800. Assuming the vehicle is still worth more than about $15,000, my solution is viable. This does, of course, assume a relatively large down payment. The point of a vehicle, to me, is to conveniently move things and people from point A to point B. As such, spending more than about $6,000 on a vehicle does not make sense to me. There are investments to be made! Vehicles are a money-sink.
Back to the reader's email - although not specifically asked, if worried that your money is not diversified, you could invest in a target date retirement fund until you have enough saved for the funds you're interested in. As an example, I know Vanguard has the initial contribution for their target date funds at $1,000.
Posted by: Freedom Fighter | July 23, 2013 at 10:09 PM