Most people feel uncomfortable about having debt and want to get rid of it as soon as possible. Believe me, I’m a huge proponent of living a debt-free life. But before you pay down a debt early, it’s important to consider the other options you have for your money. Ask yourself, how can I use my money to get the highest return? The surprising truth is that some types of debt are actually good for you. That’s right; getting rid of certain types of debt could actually be a bad idea.
Should You Invest Now or Later?
Here’s what I mean: When you pay off a debt that costs you 15% in interest, it’s just like getting a 15% guaranteed return on your money after-taxes. That’s fantastic because you’d be hard-pressed to find a similar or better investment in the real world. On the other hand, paying down a debt that only costs you 2% or 3% after-taxes is an inefficient use of your money because you could invest it conservatively and make 5% to 7% after-taxes instead.
Additionally, the longer your invested money grows, the more you take advantage of the power of compounding interest. Investing small amounts today can yield far greater returns than waiting to invest until after you pay down a debt sometime in the future. The bottom line is that when sending extra money to pay down a debt early means that you overlook investing for retirement, you may be making a huge mistake.
Is It Better to Invest or Pay Down Debt?
In order to build wealth you should spend your money where it can ultimately benefit you the most. Sending an extra payment to your mortgage each month instead of investing in a workplace retirement account or an IRA may be a great idea-if you’ve already got plenty saved for retirement. But if you don’t have a healthy nest egg, consider that you’ll probably earn more by investing your money than you would by using it to pay down an inexpensive debt.
3 Reasons Not to Pay Down Debt
So, what are the types of debt that you ought to keep? Here are three situations when it’s not smart to get out of debt:
- Your debt is tax-deductible. There are a few types of debt that come with built-in tax deductions. That’s a nice advantage because it makes the debt less expensive on an after-tax basis. There are three common tax-deductible debts: mortgages, home equity loans or lines of credit, and student loans. Some or all of the interest you pay on these types of loans can be used to reduce your tax liability. If your after-tax interest rate is less than what you’d earn on an investment, opt to invest your money and keep the debt instead.
- Your debt has a low interest rate. Interest you pay on debt, such as credit cards and vehicle loans, isn’t tax deductible. But in some cases, the interest is so low that you’re better off keeping the debt. For instance, if you have a car loan that’s less than 5% or an extended no-interest financing offer, use your extra cash to invest for your future instead of paying down the debt.
- Your debt is secured by an asset that will appreciate. When you finance something that’s likely to increase in value-like real estate or a business-it’s an investment. Using debt to buy an asset that grows more valuable over time is a smart way to build wealth.
How to Know if You Should Borrow Money
It’s a great time to use debt to your advantage because interest rates are so low. Though debt that’s tax-deductible, has a low interest rate, or is used to purchase an appreciable asset has advantages, you should never borrow more than you can truly afford. Debt that doesn’t have these characteristics, such as high-interest credit cards, should always be avoided. Financing clothes, furniture, or a vacation on a high-interest credit card is a losing proposition. Those things have no future value and can end up costing you two or three times the original purchase price, depending on how long it takes you to pay them off. So choose your debt wisely and understand when it hurts your finances and when it can be used wisely to create a more secure financial future.
Laura Adams is the author of a new book, Money Girl’s Smart Moves to Grow Rich. Pre-order it now at MoneyGirlBook.com or from your favorite book seller. She blogs and hosts the Money Girl weekly podcast on Quick and Dirty Tips. The views and opinions expressed are strictly those of Laura Adams and MoneyGirl and not of CreditReport.com. CreditReport.com assumes no responsibility for the accuracy of this information.