We have had many discussions about how to pay off debt but you may be asking, “Why should I pay off my debt?” or “Is it that important to be debt free?” Is it important? To me, that’s like asking “Do I need to drink water to survive?” Easy answer is yes. But why? That is what we will explore.
Debt is a Curse
Debt is a curse to so many. It plagues the average person and will keep them in financial ruin. You may make good money at your job, but thanks to your monthly debt payments, you can never seem to get ahead. Only barely having enough to cover your debt payments and your monthly expenses. Or maybe you don’t have enough after your debt payments and you keep adding to your debt each months. That is a vicious cycle.
You need to get out from under your debt, especially any consumer debt you may have. Interest is killer. It is designed to destroy your finances. The higher the rate, the more deadly the debt, just how that works. The more debt you have, the closer you are to financial ruin. The problem lies with this; the more debt you have, the higher your payments, meaning you have less to spend on normal expenses, leading to more debt accumulation to buy even your groceries. It is not a kind cycle to many.
The True Enemy: Interest
Why you should pay your debt as fast as you can comes from one word: Interest. Interest is the worst when it is working against you. Interest is the amount of money you are paying to borrow money. It is paid on top of the Principal amount, or the amount you are paying back of what you borrowed. At the beginning of a loan, when the balance is at its highest, you will find most of your payment goes to interest, not principal. This leads to a slow payoff of the total balance of your debt.
The above chart hits close to home for me. It is the first year of our mortgage. At the time, we had enough to just pay the monthly payment along with my increased student loan payments. So this is the actual of what occurred for us during this time.
The loan started at just over $287k at a rate of 4.25%. Not huge but you can still see the effects. With a monthly payment of $1,412 we did not have a single month with the interest portion of the payment under $1,000. Think about that. Over 70% of our monthly payment was the cost of borrowing the money. Insanity. If we kept paying the normal monthly payment, we would pay over $500,000 towards our mortgage. Almost double the original loan. Debt is designed to keep you down. What are you doing when you keep making those payments each month? You are funding someone else’s retirement. Instead of funding yours.
Opportunity Cost: The Real Cost of Borrowing
Do you remember compounding? What would the above example look like if you invested the money instead of using it to pay off debt? The mortgage is for 30 years so we will look over 30 years at the rate of return of 7%. Get ready to have your mind blown.
$1,734,059. That is how much you would have after 30 years. This is called the opportunity cost. What does that mean? Basically, you gave up the opportunity to do something because you decided to do something else. So by deciding to buy the house using a mortgage over 30 years you would give up the opportunity to invest your payment instead.
So what is the real cost of the debt? Well first you have the total payments you would be making on the mortgage: $508,343. Then you take the opportunity cost of using the money to invest: $1,734,059. Add those two up and you have $2,242,402. Of course, you have a house. Let’s assume the value of the house at the end of the mortgage is $400,000. By paying the mortgage off after 30 years, you have an asset worth $400,000 that you could utilize. Which, as you can tell, is less than the total payments made on the debt. But at least you have something.
So where does that leave the opportunity cost of your choice? You have a total cost of the mortgage payments at $508,343 less the value of your home at $400,000. So that is expense of $108,343. If you invested the money, you would have a total investment balance of $1,734,059. Add that to the expense of the mortgage scenario and you have $1,842,402. Based on the math above, by investing, you would have a total asset balance of $1,842,402 more than by having the mortgage payments. But of course, we aren’t discussing the alternatives to where you would be living. There are so many variables when discussing what should be done, it is hard to catch them all. The above is but a simple example showing the power of debt and compounding.
Why Pay Off Debt?
To solve my little housing problem from above, the choice is easy for my wife and I. Pay off our mortgage as fast as possible. Then we will start hitting our investments as hard as possible, leading to the life we dream of. This gives us the house to live in, then the ability to live life on our terms. That is what I want to teach others to do. To take control of their financial lives. So they no longer have that stress in their lives and begin living on their terms. It doesn’t have to be done all at once. In fact, that is probably an impossible task.
Instead, we all need to make choices daily that will lead us to our goals. Say no to going out to lunch and spending $10 a day. Start making coffee at home instead of buying at Starbucks. Prioritize your financial health AND your physical health. Give yourself the best life you possibly can. We all have the ability to make our dreams come true. All we need to do is start living like it!