Popular opinion and common sense dictate that debt is inherently bad; you owe someone money and will have to regularly pay them until the entire sum you borrowed is returned - plus some on top (interest). So, it makes the most sense to pay off the debt entirely in one go, if you have the money, that is. However, this isn’t always true. In some cases, it may be beneficial, if not profitable, to keep some debt. This idea is the opposite of intuitive, so I’ll be exploring it in-depth in today’s article.
To first understand why maintaining some debt might be good, we have to first explore two key ideas: interest, and opportunity cost.
Interest is the additional fee you have to pay when you take on debt; it's the way a lender makes money. Interest is in the form of a percentage of the total loan amount and is due alongside your monthly payment. The higher the interest rate, the more you will have to pay. I discuss interest in detail here, and why it exists here.
Opportunity cost is the idea that for any decision you make, you will be missing out on the potential profit that could have been made if you had chosen a different option. For instance, if you spend $200 on a new pair of shoes, you miss out on any profits that you could have made if you had invested that $200 into a business, like a lemonade stand. Similarly, if you build a basketball court in your backyard, you miss out on the potential profits you could have had if you had used the land to plant a garden and sell vegetables.
While these are both extreme examples, opportunity costs exist in most decisions you make. Thinking about opportunity cost in everyday life isn’t very helpful, in fact, it could prevent you from living comfortably, however, when making major financial decisions, like paying down a large amount of debt, it is important to consider opportunity cost.
Now that we’ve explored opportunity cost and interest, let's talk about why maintaining certain kinds of debt could be helpful.
The lower your interest rate, the cheaper your loan is. The closer your interest rate is to 0, the closer you are to borrowing money for free (because you aren't paying a fee for borrowing the money, you're simply paying it back).
As such, if you have an interest at or near 0%, it is almost always a good idea to consider keeping the debt, meaning you continue making monthly payments as usual, without trying to pay off the debt faster by making larger payments.
Consider keeping loans open if you think you can get a better return on your money elsewhere; for instance, if you run a business and think you would make more by putting money into your business then you would save by paying off your debt. Similarly, if you're getting low-interest rates, and you believe that you could make more by investing cash into an investment, like a stock index, consider keeping your loan.
However, keeping debt depends on your faith and belief in an alternative; for instance, if you are confident investing in index funds will provide you with more profit than you would save if you paid down a loan, then it would be worth considering. However, if you’re unsure of how well an investment will perform or are considering putting money into a speculative investment, paying down your debt may be a better use of your cash.
To make this clearer, let's look at the following example.
You have taken out a loan for $10,000 to buy a car. Your interest rate is 3%, and you have 5 years to pay the loan back. This means your monthly payment will be $180, for 5 years.
Let’s also say you have a business opportunity, which requires you to invest $10,000, but you’re certain you would get a return of 5% every year on that $10,000.
You have $10,000 in cash, which you can use to either pay back the car loan or invest in the business.
In this case, it would make more sense for you to invest in the business. Over the span of 5 years, you would lose $781 on the car loan due to interest. However, over that same time period, you would make $2500 (5% of 10,000 every year for 5 years) on your investment in the business. This means you would profit $1719 because you made $2500 and lost $781 (2500-781=1719).
Let's put a twist on this situation, and say your interest rate on the car loan was 10%, while your return from the business stayed the same at 5%.
In this situation, it would make more sense to pay off the car loan, because, over the span of 5 years, you would lose $2,748 to interest on the car loan, while you would profit $2,500, leaving you with a loss of $248 (2500-2748 = -248).
In short, when it comes to deciding whether to keep or pay off debt, examine how much you would save on interest, and how much you would make on another investment.
Remember, almost no investment guarantees a profit, so make sure you are careful when looking at holding short-term debt. You might think to keep a 2-year loan, and instead invest your cash in the stock market. However, there have been many times in the history of the stock market during which indexes returned negative over 2 years, while there have very few instances of losses over the span of 10 years. As such, your willingness to wait, and your need for cash is also a key factor when considering paying down debt.
Each situation is unique and depends on a number of factors. Make sure you consider how reliable an investment will be, and what your timeframe is. Also, consider factors like peace of mind and stability. In next week’s article, I’ll be discussing a few reasons why you should consider paying down debt, even low-interest debt.
My goal is to not give financial advice but instead inform and educate you on the different possibilities and outcomes that exist when it comes to personal finance, so you can make the decision that best suits you. As always, thank you for reading, and I’ll see you next Wednesday.
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