A whopping 80% of Americans are in debt, and many are working as hard as they can to pay off their loans as quickly as possible. While trying to become debt-free is a popular sentiment in the personal finance community, it’s an incredibly dumb piece of financial advice. To help you understand why paying off your loans early is dumb, I’m going to tell you how debt works, why paying off your loans early isn’t as helpful as you think, and how investing can make you a lot richer.
How Debt Works
Debt is a financial tool that you can use to buy something that you can’t currently afford. You read that right. You can’t actually afford the things you’re buying with debt even though you can afford the payments.
Whether it’s a house, university tuition, or a car, you’re taking out a loan because you don’t have enough cash on hand to make the purchase. To make up the difference between what you have in cash and the price of whatever you’re buying, you take out a loan. To do that, you ask someone, usually a bank, who has enough cash on hand if it will lend it to you.
The bank isn’t going to just give you their money for free though. They also want something out of the deal, so they charge you interest on your loan. Your interest charge is a percentage of the principal or the amount you borrowed and is charged at regular intervals, usually monthly. The longer it takes you to pay back your loan, the more you’ll end up paying in interest. Since you can save some money on interest by paying off your loan faster, people tend to prioritize paying off their loans quickly to maximize their interest savings. But there’s one GIANT problem with this.
Why Paying Off Your Loans Early is Dumb
The problem is the opportunity cost of paying off your debt fast. By putting extra money toward your loans to pay them off early, you forego the opportunity to invest your extra money instead. When you’re evaluating two opportunities, like whether to pay off debt or invest, you want to end up picking the one that will make you the most money. The winner between these two is usually investing.
Before breaking down how much money you’re losing by paying off your loans instead of investing, I have to point out that there is one exception to this rule. Credit card debt. The interest you’re charged on your credit card debt is typically at least several percentage points higher than the return you could expect to receive from investing. Some credit cards actually charge you more in interest than Warren Buffett makes in the stock market, and he’s one of the top-earning investors! So if you have credit card debt, put as much money as you can toward paying that off first, then take the advice in the rest of this post.
Ok, back to why investing is usually a much better opportunity. Let’s say you took out a loan on a $250,000 house at a 3.5% interest rate for 30 years. If you pay an additional $100/month on your loan, you’ll only save about $24,000 in interest and cut down your loan by just 4 years. While $24,000 may seem like a large savings, remember that this savings took 26 years to accumulate. That’s means you saved less than $1,000 each year.
So what would investing that extra $100/month have gotten you? If you’d invested it into the S&P 500 and received a 10% annual return, you would have over $131,000 after 26 years! That’s $111,000 more than you would have saved by making extra loan payments! Even better is that since you won’t be putting that $100 toward your loan, it’ll take you the full 30 years to pay it off, but investing that $100 for that long will give you even higher earnings of $197,000!
You might be thinking, ok but what if I paid an extra $1,000? That would cut my interest down way more, right? It sure would! You would end up saving almost $100,000 in interest and shorten your loan by 17 years! That’s an incredible savings but still pales in comparison to what you could earn by investing instead. The total you would earn from investing $1,000/month for 13 years, assuming a 10% return, is almost $300,000! After 30, over $1.9 MILLION!
So which would you rather have? $197,000 after 30 years or $24,000? $1,900,000 or $100,000? And this, my friends, is the reason why using your extra money to pay off your loans early is dumb.
What to Do with Your Money Instead
While you shouldn’t pay off your debt early, it is incredibly important to make your minimum monthly payments in full on all of your debt. Once you’re making all of your minimum payments, as our examples show, you need to use your extra money to invest and start building your wealth.
An important note is that if you lower your payments to the minimum and don’t invest the difference, you will just be losing more money to interest. For investing vs paying off debt to work, you have to actually invest your extra cash, not spend it.
So how do you do this? My favorite way is to invest in the stock market because historically, it has always gone up and provided positive returns on well-diversified portfolios. Another plus is that it is super simple to do it. Contrary to popular belief, successful stock market investing can be done with little time and effort. If you’re interested in how you can become a lazy investor and eventual rich bitch, check out this post on how to start investing.
It’s time to stop falling for all of the debt-free advice that’s out there. It’s dumb and isn’t increasing your wealth. To truly build your wealth to the tune of hundreds of thousands or millions of dollars, so you can become a rich bitch or simply retire one day, you’re going to need to invest. The earlier you start investing, the more money you’ll make. So go lower your debt payments to their minimums, and start automatically depositing the difference into an investment account, so you can get rich!