“Get rid of ALL your debt.”
We hear that advice all the time.
But does it really make sense to avoid debt all the time? Is there such a thing as “smart debt” that can help you improve your situation? And when does it make sense to keep carrying your debt, even if you could pay it off a little faster?
Debt that Helps You
It feels counterintuitive, but debt can actually help you.
Think about it: if you want a house, are you going to be able to just hand over $200,000 in cash?
Your mortgage allows you to buy a home when you might not otherwise be able to make it work.
A mortgage isn’t the only type of “smart debt” that can help you accomplish some of your goals. Many people use student loans to get an education. I know I wouldn’t have been able to finish my master’s degree without the help of student loans. My debt helped me specialize and start a good career that has allowed me to care for my family.
Even getting a loan for a car can make sense, depending on your situation. If you need reliable transportation to work, and public transit is impractical, a car loan can help you get from point A to point B.
When you can better your situation with the help of debt, it can make sense. However, you do have to be careful. It’s easy to fall into the trap of justifying debt, even if it’s not actually helping you improve your situation.
Be Careful About Your Debt
Yes, you can use debt to help you better reach your financial goals and milestones. But let’s not get carried away.
First of all, you need to figure out what you actually need in terms of debt. Don’t borrow more than you need or can afford. Getting a loan to a state school is different from borrowing to a high-priced private school. If you can get the education you need at a less-prestigious school, get the smaller student loans.
Also, be realistic about what you actually need. Don’t take out student loans for what you don’t need. Keep it to covering tuition and fees. If you need a car to maintain your employment (and income), don’t rush out and borrow $30,000 for something brand new. Instead, spend $10,000 on a reliable car that’s older. You’ll save on interest and other costs in the long run.
Don’t justify loans for consumer costs that won’t actually help you in the long term. While a mortgage or student loans can be “smart debt,” using a loan to pay for a vacation or to support a lifestyle you can’t afford is not the same thing. It’s important to understand the difference between
It’s important to understand the difference between using some debt to get ahead or better manage your situation, and using debt to boost your status or lifestyle.
Which Debt Should You Pay Off Quickly?
While you don’t want to be stuck in debt for a long time, the reality is that it makes more sense to focus on some types of debt instead of other types.
If you have high-interest consumer debt, like payday loans and credit cards, those should absolutely be tackled as quickly as possible. Paying interest means your money is going into someone else’s pocket, and you aren’t getting much in return — other than the privilege of using their money for things you can’t afford.
Things aren’t so cut and dry when it comes to paying off other debt early. Some types of debt come with advantages, like being tax-deductible. Your mortgage interest might be tax-deductible, and your student loan interest can be as well. You can even get a tax deduction on the interest you pay on business loans. So, if you borrow to start a well-though-out business, you can get a little bit of a tax advantage.
These tax-deductible loans also generally have lower interest rates. Mortgages have low rates on top of being tax-deductible. In some cases, you can also get lower rates on student loans. In these cases, paying off your “smart debt” early might not make a lot of sense.
You could put the extra that you would use to pay off debt into investments and do better. If your potential return outstrips what you’re paying in interest, it can make sense to invest instead of trying to pay off debt early.
Paying down debt is like getting a guaranteed return. If you pay off your mortgage early, it might be like getting a 4% return on your money each year. But if you can get a 8% annualized return by investing, it might not make sense to put an extra $300 a month toward paying off your mortgage early. You could do better over time by investing it.
In the end, it’s important to consider your financial situation and the possibilities. Don’t get so caught up in the idea of having no debt that you neglect the most efficient way for your to build wealth over time.