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.
{ 15 comments… read them below or add one }
My threshhold is 5% after tax. Any debt over 5% should be paid down aggressively (unless it means skipping 401k match, as you mentioned.)
However, student loans and mortgage interest are tax deductible. Thus, 5% interest on a student loan is actually more like 3.75% – IF YOU ITEMIZE YOUR DEDUCTIONS (if you don’t itemize it doesn’t matter).
Student Loans are not an itemized deduction. They are an adjustment to income. On the otherhand, mortgage interest is an itemized deduction. Your statement above is false.
I look over the amortization of the loan and determine the total interest paid over the life of the loan. Any time where the total interest exceeds the principal amount I definitely would pay off, while less likely the smaller it is. I usually find the threshold to be about 5-6% as well, regardless of deductions.
To add into your situations, what about maxing out IRAs and 401k? It’s not so much as getting a guaranteed rate of return, but the opportunity to invest. Would foregoing 1-2 years of contributions at such an early stage be worthwhile for a 5% return and early elimination of debt?
Re: Chris’ comment, student loan interest is deducted “above the line” (to Adjusted Gross Income, rather than from AGI) so it is not dependent on one itemizing to be deducted.
Funny that you should post about this because I was planning on suggesting a similar topic. I, myself, have a few low-interest student loans to pay off. Though I currently have no paycheck (thereby putting a halt on much of my finance plans), I do intend to make larger-than-minimum payments on my loans. This, however, could change if my next employer matches 401k contributions. I’ll have a handful of calculations to do to figure out which is worth it!
First, however, I’ll be needing a job!
Seems you make the case to pay off low-interest debt as if you have money already in the bank, but I’m not sure a lot of Gen Yers have enough money to pay off something like a student loan. The question for them isn’t what to do with $10,000 they have in a bank account, it’s whether they should put a monthly payment toward low-interest debt or savings/investment.
If you’re in the situation of deciding whether to put a percentage of your monthly income toward low-interest debt or investing it, what would you suggest?
@Nick – I think it’s up to the individual. Either way, they are putting their money to good use. In other words, the only wrong solution is to just do nothing.
Excellent point, RJ. Thanks!
I agree with Nick’s line of thinking, the real question most people deal with is not having $10,000 in the bank but rather a steady paycheck coming in and deciding upon the allocation of funds.
I like to look at debt as a percentage of my take home pay and try to keep everything under 50%, to include mortgage, cars and any installment loans. I have 10% of my paycheck taken out for my 401k plus I invest $100 a paycheck in my Roth and $100 in my wifes Roth every paycheck. When we get enough money saved up we make our final contributions to our Roth’s to max them out for the year.
Of course, Illinois just passed a tax increase on personal income from 3% to 5%. This isn’t the end of the world as this basically negates the 2% federal decrease in social security withholding.
@Patrick and Nick.
I’ll have to elaborate more on this topic in an entire post. You’re right, seems like a lot more people are dealing with cash flow rather than one large lump sum. (Although the idea from this post came from an email from a reader)
This discussion is never easy and has so many variables that can make each side valid for a particle person and their goals. From a strictly loan term investment discussion it pays to pay off the loans and be strict in applying the foregone payments into another long-term investment source. If you have near term goals that need cash and do not qualify for a low interest loan than I say wait to pay off the loans (see my example below).
My two low interest debts have a remaining balance of:
Student loan $15k @ 6% fixed interest
Car loan: $7k @ 4.5% fixed interest
I have the cash in savings to pay these both of in full yet I choose not to. The reason being, other opportunities that I will need near term cash for that would not qualify for a low interest loan. I plan on getting engaged and will need to purchase an engagement ring, than I need to pay for a wedding. To get a loan for a ring and wedding would most likely not qualify for a low interest loan, therefore I continue to save and pay the monthly payments on my loans. I battled around this decision for a while, but I’m two years into the car loan and 5 years into the student loan, so I have already paid most of the interest and now paying off mostly principal.
I just want to be clear that I was not criticizing RJ or this post in any way. This is a great blog I truly learn from reading. It’s impossible to think of every situation someone may be facing, and I appreciate RJ doing a great job of helping all of us. Keep up the good work!
RJ, I agree completely!
Also, it is such a wonderful feeling to free up your after-tax income that would otherwise go to debt payments after the debt is finished!
I have $52,000 in a pertsonal ING account earning 1% interest. I have a business car loan for $20,500 for 5 years and am only 3 months into the loan. The interest rate on the car loan is 4.69% and is tax deductible. Do I give my business a loan for $20,500 to pay off the car loan and then pay it back to my personal account? I am in the 15% tax bracket. Any advice would be greatly appreciated!!
Student loans are not tax deductable once you make over a certain amount of income…so the benefits of holding on to the loan if you’ve got tons of cash to pay them off are slim. Investing the money in other areas is an option but I am just trying to simplify my paperwork at this point! If you are having trouble deciding….pay off half.