If you’re like most Americans, there is a good chance you have debt as less than a quarter of Americans are actually debt-free. With the average household owing over $130,000, paying down debt may naturally seem like the best option with any available money.
But that’s not always the case.
If you’re managing your budget properly so that you have positive net income (making more than you’re spending), what do you do with that extra money?
Do you use it to pay down debt?
Save it in the bank?
As you determine how aggressively to pay down debt, there are three very important factors to consider:
It can feel empowering to throw every dollar you can at aggressively paying down debt. But it’s important to remember what qualifies as “every dollar you can.”
You don’t want to pay down debt so much that you are back to living paycheck to paycheck. Building up an emergency fund should take priority over employing the debt snowball or debt avalanche strategies.
The goal of an emergency fund is not yields or returns, but safety and options.
You never know when that rainy day might come. The day your refrigerator breaks. Or car needs major repairs. Or worse totaled. The day you lose your job. Or get invited to that destination wedding you just have to go to.
The emergency fund provides you safety from life’s unexpected costs, but also gives you the freedom to make choices you wouldn’t otherwise be able to. Relocating to a new state (or country) or switching careers may be difficult without the ability to handle the transition.
When you pay down debt, you can’t pull that money back out if you need it.
The one instance where you can is if the debt is backed by an asset like a house or a car. Your payments build equity and by selling you net that additional amount. But most of the time it’s not practical to sell or refinance your home or car.
Let’s say you have $10,000 available (after your emergency fund) and are considering eliminating a big chunk of student loan debt. If you were to put that same money in stocks, you could sell it at any given point and have it back in your bank account in a few days. This is one of the reasons I put our whole savings into stocks.
Your liquidity needs depend on your goals.
If you plan to purchase your first home in the near future, paying down your student loans may prevent you from having enough cash for a downpayment.
Consider the opportunity cost of only illiquid equity. One of the life lessons that I learned from stock trading is that opportunities are abundant, but the window of opportunity is scarce. Just like you never know when accidents may happen, you also never know when opportunities may arise.
Want to start a new business? Or jump on a great investment opportunity? In order to capitalize, you may need liquid assets.
One great thing about making extra debt payments is that you know the exact return you will achieve. It’s a no-risk return. Which in today’s world is hard to come by. You’re more likely to get a return-less risk.
No matter what decisions you make there are always going to be risks.
The risk of money sitting in your bank account and making only 0.03% per year. After inflation, that’s a negative return. The risk of paying down debt and missing out on huge market returns or life opportunities. Of putting money in stocks to have high liquidity but suffering losses.
When you’re paying down debt, you have to be happy with the return you’re getting (aka the interest rate). You’re banking that guaranteed return knowing you could miss out on certain opportunities or higher potential returns but reducing risk.
As you can see, these three considerations when paying off debt are very interconnected. It’s a balancing act. Change one factor and it affects the others. There is no one size fits all.
Each person’s situation, needs, goals, and psychology will determine where to put more weight. Before you pay down debt, consider what is right for you. Hopefully one day we’ll both be part of the debt-free group — which will make the decision much easier!