When I first decided to get smart about my finances, I was deep in debt. I had maxed out both of my credit cards, I’d gotten myself into a 9% car loan, and I wouldn’t even look at how much I owed on my student loans. I needed to get my head out of the sand.
Once I figured out the sorry state of my finances (thanks, Mint!) I got busy. I took on extra jobs. I saw how much I was paying in interest, and I threw every extra dollar (and some that didn’t feel like extras) to my debt-of-highest-pain.
Then I read an article about how someone was saving half his income (not unlike the post I wrote this month), and my first thought was, “psssh! I could never do that! I have more debt than I know what to do with!”
But then I started thinking about it. I’m putting at least half my income somewhere. It doesn’t feel like savings, but is it?
Paying Consumer Debt Is Money in the Bank
The way I see it, I had two options. One was to file for bankruptcy and lose any and all chance at ever having good credit again ever. I looked into it, but promptly ruled it out because the negatives far outweighed the positives. I “only” had $25,000 in debt, not $200,000.
The other option was to pay all that debt back. Bit by bit, dollar by dollar, month by month. I had to pay it back.
I was paying interest on everything, too. One of my cards had an interest rate of over 20%. So, every extra payment I made was, in effect, earning me 20% interest.
How Is It Earning Interest?
Let’s use an example. Let’s say you have a credit card bill with a balance of $10,000, and an interest rate of 18%.
Option A: Pay the Minimum Balance
Paying the minimum balance of 2% means it will take you nearly 51 years to pay it off, and you’d end up paying a total of $38,000.
Option B: Pay a Little More
If you decided to try to take it a little more seriously by increasing your payment from 2% to $200 every month, it will take you almost nine years and you’d end up paying $18,600 to rid yourself of the debt.
Option C: Pay Half Your Income
Now let’s say you really buckle down and dedicate yourself. You scrape every extra penny you can, and pay $950 every month. You could finish paying that off in one year, while paying a total of $10,967.
By paying $750 more a month, you are saving yourself over $17,500 in the long run. That’s money you’ll have for the next eight years that would have simply gone to the bank.
Let’s say you went with Option B listed above, and used the $750 a month to invest into a low-cost, broad based index fund for a year ($9,000 total). After the eight-year period in which you finally pay off the debt, your $9,000 is worth about $16,000 (assuming an average annual rate of return of 7%) while paying $18,600 in interest.
Here’s the kicker: the 7% we’re assuming is based on an historical average. Any honest investor knows you can’t predict what the markets will actually do, so you could have a lot more than $15,500, or you could have a lot less.
In the meantime, that $17,500 you save by paying off the debt in a year is the exact same thing as getting a guaranteed 8.5% return on your investment! You will never find an investment that can guarantee a return. Not ever.
You can, however, guarantee that you won’t have to pay the interest if you pay off the debt faster. Check out your options using this calculator.
An Important Caveat
This math works for people on the road to debt freedom. It’s not intended to reward you for buying shoes on a credit card and paying them off in five months. If you’re still actively getting into credit card debt, then earmark this article for another time. But if you’re on your way out of the throes of consumer debt, use this as a motivator. Every extra dollar, every extra ten dollars, that goes toward your credit card is in fact savings. Sure, you can’t withdraw from it, but soon, you’ll be seeing the other side of debt, and you’ll feel that weight lifted off your chest.
Pay it off!
Is Paying off Debt Savings? Perhaps not technically, but …
I’ll take a guaranteed return ANY DAY.
Image credit: fviggiani