If you have the money, should you pay off a low interest debt?
For example, what if you had the money to pay off the rest of your car or student loan, should you do it?
This is a financial situation where most young adults are now or will find themselves soon. While it’s hard to decide the best situation for everyone, there are some general guidelines to discuss, so you can make the best decision for yourself.
What Is Low Interest Debt?
I find you can get a lot more from this post, if you know exactly what low interest debt is. Unfortunately though, it’s not an easy definition.
As a general rule, I draw the line at 6%. Anything above 6%, I would categorize as high interest debt, which should be paid off immediately. Anything below 6% is low interest debt and this is where it’s not always the best move to pay it all off.
Why 6%? Because paying off debt in an investment.
Say you prepay a 10% loan by $100 every month. Each time you prepay, that’s $10 less in interest you have to pay next year. Therefore, your return on that $100 is 10% per year. Keep in mind that this return is guaranteed, involves no extra costs, and is tax-free.
Compare this to investing in the stock market. On average, you earn around 8% a year. Therefore, if you used that $100 to invest in the stock market, your return on average would be 8%. Although remember that this investment is not necessarily after-tax, there are transaction fees, and it’s far from guaranteed.
The Case for Paying off the Low-Interest Debt
In the scenario above, you can see that it’s better use of money to pay off the debt instead of investing. This is because this is a high interest debt. The purpose of this post is to discuss what should you do when it’s a low interest debt and you have the money to pay it off.
Say you have a 5% student loan for $10,000. Due to some hard work and savings, you have the money in the bank to pay off this loan. Should you do it?
In my opinion, yes! Get rid of the debt as fast as you can.
Even though there is a chance you can earn a higher return elsewhere, I would still pay off a 5% loan if I had the money. It’s a 5% guaranteed after-tax return, which is an investment that doesn’t come by often.
I can think of two different situations where I would choose to hold the cash and make minimum payments on the debts.
- Hasn’t Maxed 401(k) Match - If I had to choose between maxing out my 401(k) employer match and paying off a low interest debt, I would rather max out my 401(k) contributions. With the matching contributions and the right asset allocation, a 401(k) contribution with employer match will give me a higher rate of return on my money.
- Uncertain about Career/Job Stability – Say I had $15,000 in student debt left at 4% and I had the money to pay that off in full. In a situation where I was uncertain about my job stability or my career in general, I would continue to make minimum payments on the loan. I don’t mind paying a few hundred dollars in interest every year, if the result is career flexibility and a good night’s sleep.
In the comments, let me know what you would do if you had a low interest loan and the money to pay it off.