We talk a lot about eliminating debt and increasing net worth, but in specific situations paying off debt as quickly as possible is not the optimal decision. While charging up a credit card with a high APR is never a good choice, certain kinds of debt with certain interest rates may be worth keeping for longer periods of time than other debts.
I am particularly debt-averse. If I can extrapolate a remote reason why it could be better to pay off debt early, I use it as justification to pay the debt off early in less-than-prudent scenarios. But we still have a mortgage on our home because it is one of those debts that would be so ridiculous to pay off early that even I have to accept paying as we go. This debt, along with others worth paying off slowly, has particularly qualities that make it worth choosing debt rather than early payment:
1. It is not revolving debt.
Revolving debt is debt where you borrow against a line of credit and do not have a fixed debt repayment schedule. The most common examples are credit cards and home equity lines of credit. Revolving debt is more likely to have high and variable interest rates, and it is also the kind of debt that impacts your credit utilization. Since it impacts this important part of your credit score and accrues interest at varying rates, making what you owe more difficult to track, it is best to avoid carrying revolving debt over time.
So what is the opposite of revolving debt? Debt that has a specific interest rate and schedule for repayment, often called installment loans. Think of a 30-year fixed mortgage where the home loan is paid back in consistent increments over the length of the loan, a home equity loan (as opposed to a home equity line of credit), or a five-year car loan. These debts do not negatively impact your credit utilization, and they can even improve your credit mix. Additionally, installment loans are predictable and easier to budget for over time versus revolving debt.
2. The interest rate is below your expected return on investments.
Assuming the debt is an installment loan rather than a revolving debt, the interest rate is the next factor to consider when deciding whether to pay off a loan quickly or take your time with it. The lower your debt’s interest rate, the more likely you should refrain from paying it off quickly. No precise line exists where it suddenly becomes imprudent to pay off a loan slowly, and whether you should pay a loan slowly largely depends on your risk tolerance. However, there is a bit of a sliding scale from loans that you absolutely should not pay off early to those you absolutely should.
If the loan has an interest rate lower than the interest rate you can get on a high-yield savings account or a Certificate of Deposit, you should absolutely not pay that loan off early. This describes our mortgage, which has a 2.75% interest rate while HYSAs now offer 4% interest rates and higher. Even if you are the most risk averse person on the planet, do not pay this loan off early. If you can receive a higher rate of return without adding risk, it makes sense to invest that money and pay only the regularly scheduled installments of your loan.
The squishier area of loan repayment falls above the rates you can get on a HYSA or CD but below the average market returns of total market index funds. Right now, this is roughly rates above 5% but below 10%. If you are risk-averse, you should probably just pay these off now. However, if you are at least moderately risk-tolerant, approach these rates as a sliding scale with the duration of the loan: If the loan term is short, you should only pay it back slowly if it has an interest rate at the lower end of the spectrum (6–7%). If the loan has a longer term, like a 30-year fixed mortgage, you can assume that you will get market averages and pay it back slowly even if it is at an 8–9% rate. The market experiences growth over the long term, but the short term is unpredictable; this means you can bet more heavily on the market the longer the time frame. Consider your repayment in light of historic trends of the total market and adjust according to loan duration.
Any installment loan with an interest rate higher than 10% should be paid off earlier if possible, even if it is a structured and predictable debt. The reasoning is simple: You cannot count on a higher return on investment than the interest rate of the loan. If you do not have the means to repay an installment loan with a high interest rate ahead of time, that is okay. It will not negatively affect your credit score, but the sooner you can pay it off, the less interest you will pay on that loan.
3. Holding the debt does not cause you stress.
Particularly if your debt falls in the squishy zone (looking at those 7–8% loans that make decision-making difficult) and you are feeling indecisive about your plan, it is important to be able to sleep soundly with your decision. If paying off debt with moderate interest rates more quickly gives you peace of mind, then do it, even if you feel somewhat confident that your return on investment would make paying the debt slowly a better option on paper.
If your debt has a low interest rate but you are extremely risk averse, there is an alternative option to paying off the loan as soon as possible or paying it off slowly without contingencies. If your loan has an interest rate below the HYSA/CD interest rates and you have the money to theoretically pay off your loan early, you can always put enough money to pay off your loan into a HYSA now. Slowly pay off the loan using the money in the earmarked money in the account; you can even do this with automatic payments to reduce your mental load. If the interest rate in the HYSA ever drops below the interest rate on your loan, just pay off the loan. If the interest rate remains higher, at the end of your loan, you will have some leftover from the excess interest in that HYSA: That is all the money you saved from paying your loan off slowly!
If you are fortunate enough to obtain an installment loan with an interest rate so low that your safest investments have a higher interest rate, borrowing money just makes sense. Keep the predictable, low interest debt while letting your money grow and paying that debt off as slowly as the schedule allows.
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