Should You Go All-In on Paying Off Your Debt?
You can commit all your disposable income towards debt, but that's not always the best idea.
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"Pay off all your debt" is among the most popular pieces of financial advice, and there are plenty of stories about people who have devoted every dollar to doing just that. Some couples have even paid off $60,000 or $80,000 of debt in two or three years as they worked toward financial independence.
Although being debt-free is a great goal, that doesn't necessarily mean you should make it the sole purpose of your life. There are times when you should go all-in on paying off your debt, but you can't apply the same logic to every type of debt. Here's how you can decide how much you should focus on debt repayment.
Pay off credit card debt ASAP
We'll start with the type of debt you should pay off as quickly as you can, and that's credit card debt.
The average credit card APR is about 18%, and even most low-interest credit cards will cost you upwards of 10%. Since you're highly unlikely to get a consistent return of 10% or more anywhere else you put your money, you'll benefit the most financially by paying off your credit card balances immediately.
One point of contention among financial experts is whether you should drain your emergency fund to pay off your credit card debt. There are two ways to look at this:
- If you do incur an emergency expense, you could put it on your credit card anyway, so you might as well focus on paying off your credit card debt over maintaining an emergency fund.
- Not all expenses are payable using a credit card, so you should keep your emergency fund even if it means you won't be able to pay as much toward your credit card debt.
I'd recommend prioritizing your credit card debt in this situation while still keeping at least a month's worth of expenses in your emergency fund in case you need cash.
What about other types of debt?
The decision gets trickier with lower-interest debts, such as:
- Student loans
- Auto loans
- Personal loans
With these types of debt, you should only devote all your financial resources to paying them off if you can answer "yes" to the following three questions:
- Can you pay off the debt without a prepayment penalty? Some lenders charge you extra if you pay off your loan early.
- Do you already have a sufficient emergency fund? Three to six months of living expenses is the usual recommendation.
- Will you save more through paying off your debt than you could earn by investing your money? You can realistically expect to earn an average return of about 9% annually from a diversified stock portfolio, based on the historical returns of the market.
Why is it more important to have an emergency fund first? Let's say you put all your extra money into paying debts with an average APR of 8%. You'll save money on interest initially, but if you have any sort of emergency, then you may need to put it on your credit card, where you'll end up paying a higher interest rate than you were on your previous debts.
Even if it takes you longer to pay off your debt, it's safer to have an emergency fund in case you need it. And if you put that emergency fund in one of the best bank accounts, you could still earn some interest on it.
You also need to consider whether you could make more through investing than you'd save by paying off your debt early. For example, if you have a mortgage with a 4.5% APR, you could invest your money and likely earn more than 4.5% back per year.
Investing becomes an even better option if you put your money in retirement accounts that offer tax benefits.
Don't let debt repayment run your life
There's nothing wrong with putting financial resources toward freedom from debt, as it's a great feeling when you don't owe any money. However, you shouldn't let yourself get so attached to that goal that you neglect your emergency fund or miss opportunities to make more money through investing.