Welcome back to another episode of Money Smart Monday!
Today I’m going to be talking about the pros and cons of debt. I know that sounds a little weird, especially because debt can be costly no matter what kind of debt you have. Having said that, there are a lot of questions over should I pay off my mortgage early, or should I invest in the stock market? What should I do with this bonus that I just received? Should I pay off debt or should I put extra payments towards debt?
So hopefully this will give you a little bit of clarity over what you might want to think about if you’re ever in that situation.
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Good debt vs. Bad debt
You hear of things like student loans or a mortgage on a home as being good debt. When we say “good debt,” we mean that the interest rate is fairly low. Even though you might spend a lot of money on paying back that loan – certainly people that have student loans are paying tens of thousands of dollars in interests when they are going to repay that loan – they are getting some return out of that investment as well.
For example, in theory, you should get a higher paying job with a college degree than you would if you didn’t have a college degree. So even though it’s costing you money to borrow those funds for a four year education, you’re getting a much higher return from it which is why we say it’s good debt.
Bad debt, on the other hand, is something that has an extremely high interest rate and you’re not really getting much of a return on it. Think of something like a payday loan, or a title loan, let’s say, for your car. You’re borrowing money at an extremely high interest rate and you’re not really getting much of a return back on that.
With something like vehicle debt, it’s not really good debt but it’s also not quite as bad as a payday loan. The interest rate might be 4 or 5% depending on what kind of car you purchased, but the cars don’t last that long. Cars are a depreciating asset which means the value of that car goes down over time, so that’s why it’s not really necessarily a good debt.
Mathematical vs. Psychological
There’s a lot of people that say, “Okay, well I’ve got this extra money. I can make more money by putting it into the stock market and have it grow at maybe 8 or 9% over time than paying off my really low interest mortgage payment.” That can work for some people, however, there’s sort of a mathematical way to look at things and then there’s a psychological way of looking at things.
If you’re very math oriented, then yes, the numbers show that if you were to take your bonus or any extra money you may have and invest it into the stock market, as opposed to paying off a loan early, you might actually make more money for yourself having that loan in the stock market.
But there is still some risk to that. There’s risk that your money doesn’t grow as much in the stock market. There’s also risk that, for example, you lose your job and you still have this mortgage payment that you need to pay. If all your money is tied up in a retirement account, let’s say, you could be paying penalties to take that money out to pay off a loan.
Let’s talk about the psychological benefits, then, of paying off debt. Certainly if you’re in a lot of debt, you’re faced with a large monthly payment every month for something, and it’s not really enjoyable. Doesn’t matter what the interest rate is, it could be free money, but just knowing that you have to pay $500 a month to your student loan lender or $700 on your mortgage, can take a toll on you. Especially if you’re having to pay that over 20 or 30 years!
You have to consider the psychological benefit of getting out of debt. Tracy and I paid off a lot of consumer debt before we got married but we’re also left with a lot of student loans (which we still have today, unfortunately). So even though that might be good debt, we still want to pay off those student loans as much as possible because we don’t like that huge amount of money going to those student loan lenders every month. We want to be able to use that money to invest back in our business, or to invest in our retirement, and things like that.
Making the decision
This is another one of the areas in personal finance where it really depends on your particular situation and how you handle extra money that you might want to pay off debt with. I would say that if you’re more of a emotional being, then paying off debt and getting rid of those lenders will help you tremendously psychologically, and that can improve your relationships. There’s a lot to be said for that!
If you’re very mathematically or detail oriented, and you are trying to squeeze out every last dollar possible, then investing in the stock market instead of paying off a loan early is your best option.
You also want to consider what kind of debt you have as well, when making this decision. It’s really something to take the whole picture into consideration if you are ever faced with a situation where you have extra money and you’re wondering what to do with it.
Hopefully this has been helpful for you, and we’d love to have you subscribe to the channel to get more tips from us, and if there’s ever a topic that you want to hear more about or if you have questions or need clarification on something don’t hesitate to reach out to us.
Talk to you next week!
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