Why I'm Not Paying Off My Debt
As a recent college graduate I have a decent amount of debt, not a lot but I do have multiple loans. I could pay them off in full right now and be completely debt-free, but I don't think that would be financially intelligent and here's why.
Consider the Interest Rate on Debt
If your debt comes with a high interest rate, you will want to pay this off as soon as possible. It costs you more and more money until you are able to pay off the principle. Credit card debt can charge an interest rate of around 20%, so $10,000 could cost you $2,000 in interest in the first year alone. In this scenario, you want to do everything in your power to pay this off as this borrowed money is so expensive.
Low Interest Debt
In my case my student loans are just over 3% and my auto loan is just over 4%. This means if both loans were $10,000, I would only owe about $300 and $400 respectively, in interest annually. Much cheaper than the credit card's $2,000 interest charges! But you still pay interest, why wouldn't you pay this off as soon as possible?
Opportunity Cost & The Value of Time
The saying time is money, couldn't be more true. Opportunity cost is the loss of potential gains from missed opportunities.
Opportunity cost = (return on best possible action) - (return on action taken)
If we consider the opportunity of the stock market and assume annual gains of 9.8% (the S&P averaged this annual return over the last 90 years), then a $10,000 sum deposited in the market has the opportunity to turn into $10,980. Thats a $980 gain. If you have $10,000 and you don't invest it, you are missing out on opportunity and losing a potential $980 gain. Let's consider this the best possible action in our opportunity cost calculations because though volitile in the short-term, in the long-term these are very realistic and historically accurate returns.
High Interest Debts
This point is super important, and can change how we think about debt. If we go back to our various debts with interest rates, we can factor in the opportunity cost. If I have $10,000 cash I know I can get an average return of $980 from the market. If I have $10,000 of credit card debt at a 20% interest rate, I will owe $2,000. If I invest the money and make minimum payments on this debt I will end up at a net loss of $1,200 interest paid. However, if I pay the amount in full immediately I end up at a net loss of $0 and pay no interest. In this case and in situations where the interest rate on debt is higher than the expected return on investment, it make sense to pay off debts as fast as possible.
The opportunity cost would be best action minus the result of the action taken (interest payment of $0 - interest payment of $1,200), resulting in an opportunity cost of $1,200 by not paying off this debt immediately. So in conclusion if your debt comes with an interest rate of more than 10%, definitely pay this off as fast as possible.
Low Interest Debts
However, in my case my debts have fairly low interest rates associated to them. If I paid off the $10,000 debt in full immediately, I would save on the $300 or $400 that I would pay in interest. If I invested that money and didn't pay off the debt I can take advantage of the value of money over time and optimize the opportunity cost. Let's use the 4% loan in this example since it is more expensive than the 3% loan, we can assume the gains from the 3% loan would be even more significant. I know I could average a $980 return from the stock market, so if I take that return AND eat the interest payment of $400, I'll still net a gain of $580. This is the best scenario. The alternative action we could take is not invest the amount and instead pay off the debt immediately. This action would result in $0 paid in interest but we would also make no gains from the market. The opportunity cost then, best scenario (gain of $580) minus action taken (gain of $0) results in a $580 opportunity cost by paying off low interest debt instead of investing that money and earning a higher return. Paying off this low interest debt immediately would actually result in $580 in lost opportunity cost. By optimizing the opportunity cost on $10,000 I can come out $580 richer by NOT paying off this debt.
Option 1: Put $10,000 into stock market and average 9.8% return rate $980 investment gain - $400 interest paid = $580 gain
Option 2: Put $10,000 into paying off the 4% debt $0 investment gain - $0 interest paid = $0 gain
You come out $580 richer by not paying off this debt.