Should I pay extra on my student loan and mortgage debts to get out of debt quicker, or should I just pay the monthly amount due and put extra into my investments?
I’ve been asked this question more times than I can now specifically recall. My old answer was:
“Are you nuts?! Pay off the debt as fast as possible!”
Where I come from, debt is bad. The entire thought of it gives me the heebie-jeebies. My soul hurts when I remember the days of living under my debtor over-lords. I took a staunch, all-or-nothing, debt-free or bust mentality.
The problem with that solution? Everybody’s not me, and for some people “bust” might be a more likely outcome of focusing solely on debt elimination. So what’s my answer now?
We’ll get to what it depends on in a minute, but just like everything else – what’s right for someone else may not be right for another. A personalized financial game plan will include a written debt elimination strategy, but that strategy will be largely dictated by where we fall on the Math-Emotion (ME) Spectrum.
The Math-Emotion Spectrum
I call this the Math-Emotion Spectrum because, well – most people don’t live 100% at either end. Although we may feel like we’re absolutely at one end or the other, some soul-searching would probably result in us finding that we lie somewhere in the middle. “Nerds” typically end up closer to the left, and “emotionalites” (made up word) toward the right.
By the way, in the personal finance world, “nerd” is not a derogatory term, in case you were wondering.
The math-oriented decision maker will make decisions based on what mathematically works best for the present and for future projections. A typical argument I hear on this end would sound something like:
“Why would I pay off my mortgage when my interest rate is only 4% and the market has returned more than that in the past x years? Wouldn’t the net result be that I end up with more if I invest the extra money instead?”
Yes – but there are many “ifs” here. The list of “ifs” include:
- Stable employment.
- Market performance.
- Investor behavior.
- Unexpected emergencies.
On the flip-side, an emotionally-based decision maker tends to disregard the math under the duress of the perceived social and psychological ill-effects of carrying debt. Their argument sounds like:
“I don’t care what anybody says. I hate debt and i’m not going to live with it. It makes me feel trapped.”
Hard to argue against how somebody feels, and this kind of motivation can be handy in cleaning up a messy situation and getting on the right track. However, a few stumbling blocks exist here too:
- Long-term goals may be derailed depending on the size of debt.
- “Free-money” may be left on the table if a match exists at work.
- Good opportunities to add true income-generating assets may pass by unclaimed.
Notice one of the blocks is not “tax deduction on interest paid for mortgage and student loans.” That’s outside the scope of this article, but just know it wasn’t included for a reason.
What to Look For
What affects where we fall on the ME spectrum? Here are a few talking points and considerations to go over with your spouse and/or your dream-team (Financial Adviser, CPA, Attorney, etc…):
Type of Debt
There is no rational explanation – mathematical or emotional – that will justify carrying a credit card balance. You don’t need to carry a balance to increase your credit score (look it up). Pay off your balance in full each month and avoid paying 18% interest on your last t-shirt purchase at Target.
The question usually crops up when it comes to lower interest-rate debts like student loans and mortgages. Depending on the interest rates of these loans, emotionally-drive folks will argue to pay them off as soon as possible and math-oriented types will say to pay them off over time and invest the difference in the market for potentially higher returns. This is a decision you have to make as a family or a team – don’t let other people make it for you at the expense of your mental well-being.
Length of Loan
How long will you be in debt, and what are you sacrificing by going 100% in either direction? If you are 100% focused on debt elimination, but you have hundreds of thousands of dollars in debt that may take 10+ years to clean up, you are sacrificing participation in the market and the benefits on compound interest.
If you are committed to debt elimination, but would rather play it by the numbers and pay off over time, you may be adding stress to your household, and are maintaining an exposure to risk that can’t be easily quantified.
In other words, if you’re able to pay off the loan in two to three years regardless, your orientation on the Math-Emotion Spectrum doesn’t matter nearly as much as if you were committed to a 10-30 year debt.
Stage of Life
A 55-year-old that spends 10 years aggressively paying down a mortgage at the expense of investing and saving may go into retirement with a paid-for house (good thing), but with less money to generate monthly income (not so good). This can lead to borrowing against the mortgage just to survive, when a more balanced approach may have accomplished their goal with less sacrifice later in life.
Conversely, if that same 55-year-old keeps too much of the mortgage around in order to invest any extra cent, they may find themselves overextended on a fixed-income.
We all know that math matters, and that if we want to end up with a big economic engine to fuel our retirement and legacy, we need to make wise mathematical decisions. That doesn’t mean that emotion should be thrown out like a baby with the bath-water.
Somewhere deep inside all humans lies a trigger – a security gland that tells us stuff like:
“Settle down guy.”
“Let’s get out of here!”
“Don’t touch that.”
“Do it – YOLO.”
While these emotional responses can’t be easily quantified, I will say from experience that my wife’s security gland is worth (at least) 1% interest paid or gained in either direction each year. OK, fine – 2%.
The point is that in order to thrive financially, we need to make smart mathematical choices, mixed with emotional resolve and security. The two live in harmony, and too much of one at the expense of the other can lead to financial dissatisfaction.
The solution lies somewhere in between. Where do you land?