I hate debt.
It’s really that simple for me. I am uncomfortable with the idea of owing money, and so I generally avoid debt as much as possible, and I work to pay off any debt I have as quickly as possible. As of right now, the only debt I carry is my student loan and our mortgage, and I have been working my tail off trying to kill that student loan.
But at the same time that I am sending the maximum that I can afford to my lender, I am also trying to beef up my retirement savings, since that has been on the back burner for several years.
Debt feels more real to me than my retirement needs, so I have been sending extra payments to my student loan while only giving the bare minimum (or less) to my retirement.
The question is, have I been following a savvy money strategy or have I been shortchanging myself? I decided to find out.
How Much Will the Interest Cost You?
The first step in determining the best use of your money is to figure out exactly how much you will spend in interest with both your regular pay-off schedule and with your accelerated schedule.
Using an Accelerated Debt Payoff Calculator, I discovered that it will take me 40 months to pay off the $13,169 remaining on my student loan if I send the minimum payment of $360 per month, and I will pay $1,022.10 in interest at my rate of 4.5%.
If I continue sending the $600 per month that I am currently allotting to my student loan payment, I will have the debt cleared in 23 months to the tune of $599.46 in interest. So far, so good. Apparently continuing with my quick-payoff plan will save me over $420 in interest and 17 months of payments.
If you are doing this calculation for yourself, your number could be much different if you are paying off credit cards with 15% interest or more. Make sure you get those numbers right or you can throw this whole decision-making process off.
How Much Will Your Money Otherwise Earn?
Of course, those calculations only tell half the story. I also need to determine just how much my retirement accounts will grow depending on how I choose to spend my money.
Using a Savings/Investment Calculator, I found out the following:
If I pay off my loan in 23 months and send no extra money to my retirement accounts during that time, I will have $600 to send each month as soon as my loan is paid off.
In that case, starting with $0 in my new retirement account and assuming that I earn a 5% return (which is a very conservative estimate) for the 17 months that I would otherwise still be paying my loan, I will come to the end of the 40 months with $9,931.24, $331.24 of which will be earned interest.
On the other hand, if I were to send the “excess” $240 to that same retirement account with a 5% return, I would end the 40-month period with $10,147.05, $787.05 of which will be earned interest.
At this point, it’s a little hard to tell what is the correct course of action. The amount that I earn in interest in each case is pretty close to the amount I’ll be paying in interest on the loan.
Again, that’s not the entire story. There are other factors at play:
Tax deductions: Up to $2500 worth of interest can be deducted per year. In either case, I will be paying much less than that amount in interest each year that I carry the loan, so I can take full advantage of the break.
Discipline: Some people need to have a specific agenda for every dollar or else it will be spent frivolously. I tend to be a “pay myself first” type—meaning that I send that $600 off each month and then figure out how to pay the rest of my bills. With just a slight tweak in my habits, I could easily start sending $240 off to my retirement account. For others, that nice round number of $600 might be too difficult to let go of.
Future income: As a freelancer, I’m not entirely sure how much I will make from one month to the next. If I knew for certain that my flush months were going to be the norm for the next several years, it might make more sense to pay off the loan early and count on a good income to help me make up the slack in retirement savings. Since I’m unsure of what to expect from month to month, it makes more sense to send my lender the minimum, freeing up that extra money for retirement (or other needs, if necessary) until I can be sure what my earnings will consistently be. After all, I don’t have to pay off my student loan early, as long as I am making payments.
Debt-to-Income ratio: This is part of how credit scores are determined, and carrying debt for longer than necessary can negatively affect your credit. Paying off that debt early can help to improve your score.
Emotion: No matter what the numbers may say, you may feel better paying off debt early. As long as you don’t use that as an excuse to neglect your savings or retirement, there is nothing wrong with doing what feels right.
I have decided to reduce my student loan payment and send the rest to retirement. I have been ignoring my retirement needs for long enough that I feel it would be better for me psychologically to feel like I’m moving forward in that arena. And since the numbers put me slightly ahead by doing this, it was an easy decision.