One of the hardest parts about paying off your debts ahead of schedule is, until the balances are actually gone, you will not realize any benefits. In fact, in the meantime, it will actually probably be quite painful and annoying.
This is exactly why paying off debt on any kind of accelerated schedule is such a huge pain in the ass. How often do you do things that suck, make you feel broke, and stop you from going on vacation for two or three or more years? Probably never. Nobody willingly does that.
I’ve recently stumbled upon articles and blog posts by people willingly ignoring their debts. They opt for the minimum payment, because then it gives them more money to put into other investments, like retirement accounts or an emergency fund. If you don’t do any number crunching, this can almost sound like a good strategy — after all, you’re not neglecting your debt to spend more at the mall, you’re being responsible! But if you understand that a dollar is a dollar is a dollar, you know dragging out your student loans over 10, 15 or 25 year terms just for the sake of having more cash in-the-now is an excellent way to shoot yourself in the financial foot.
Example: imagine a $10,000 loan at 5% with a 10-year repayment term. Your monthly payment would be $106 per month, and over the lifetime of the loan, you’ll pay just over $2,700 in interest.
This is a small enough loan that many people would not feel in a hurry to pay it off. The interest rate is low enough not to lend any sense of urgency. The minimum payment is small enough not to dramatically disrupt anyone’s budget, possibly small enough not to be a bother at all. This is exactly why it’s such a battle to get anyone to make pre-payments on their loans: there is virtually no immediate incentive to do so. I get it.
But there are major long-term incentives.
It takes so little to get ahead
The first thing I want to address is it literally takes small peanuts to make a big dent in your debt.
Media sings the praises of people who wipe out massive sums in 2 or 3 years or less, and rarely praise the debtor who vanquished their debt in 7 years instead of 10. But that doesn’t mean they didn’t win a real battle.
Remember, you don’t actually have to whittle the balance down to zero in record time in order to realize the benefits of paying your debt down fast.
In fact, tossing as little as an extra $50 to $100 per month at your loan will likely result in a huge payoff.
Every time you make an early payment towards your debt, you’re buying time at the end
Repaying debt can feel like an exercise in futility. Making a big payment this month will not reduce your payment next month. Making 12 payments in the first six months of the year will not let you make fewer payments for the remainder. In this context it might feel like there’s no incentive to get to debt-free early.
But there is.
Every time you make an early payment against your debt, you knock time off at the end of the loan.
Often you don’t even need to make full extra payment in order to knock a full month off the term. Because of the interest that will accrue over the lifetime of your debt, reducing the principle early on reduces the amount of money that will accrue for the rest of the repayment term.
In our $10,000 loan example, one extra payment of $75 at the beginning of the repayment term will knock 1 month off the loan term at the end. This means you’re essentially getting $106 worth (one payment) for $75. That’s a $31 difference or a 41% return on your investment.
Make this extra $75 payment for 9 months in a row, and you knock off 10 months off your loan.
If you’re getting frustrated with your debt, stop looking at the balance. Start looking at the number of months you will no longer have to be in debt for. It’ll cheer you up.
The more months of early payments you make, the faster your debt-freedom date draws nearer. And the less interest you pay.
The money you save on interest by paying your debt early is real money.
The numbers in your spreadsheet can feel intangible. They are so easily altered by a minor change in variables. They seem unreliable no matter how many times you check the math. It’s like they’re not even real.
But the money you save by making early debt payments is real money. You can spend it on other aspects of your life.
Using our above example, let’s say you decide to stick to an extra $75 per month payment on top of the minimum $106 payment until your debt is paid off. You’re going to get out of debt in 63 months, which is nearly 5 years early. But you’ll also save $1,300 in interest.
This $1,300 is real money. To really understand this, you should revisit my post This Exactly How Much You Will Earn & Spend In Your Lifetime.
Picture the loan as part of a lifetime spending account. In one scenario, you stick to the minimum payment schedule and it costs you $12,727. In the other, you make your extra $75/month payments and the loan costs you only $11,410. You can allocate the difference to any other area of your life. You can spend it on travel, clothing or food. You can save and invest it. You can do anything you want.
Ideally, you’ll invest the money. But honestly, virtually any use of it is better than relinquishing it to a creditor. I want you to put that $1,300 into a retirement savings account. But if you spend it on a vacation, I won’t begrudge you. After all, you’ll probably really enjoy the vacation, whereas I doubt you enjoy paying interest.
If you graduate from university at 22, this is the difference between being debt free at age 27 instead of 32. And $1,300 richer.
Don’t tell me you can’t afford that.
29 Comments. Leave new
I think you mean “make a big dent in your debt repayment…” And “get out of debt AT 63 months” or “57 months” which makes the “nearly 5 years” make sense, because 63mo is over 5 years.
Oh, and here come the haters with “but I invested the difference and made 8-10%, so I’m just smarter than you, even though I’m too egotistical too admit/realize that I owe taxes on my gains, which are also not guaranteed, but saving on interest payments is guaranteed”
🙂
I split my original plan of 2k a month repayment (374 minimum repayment) into 1k for repayment, 1k for a brokerage tfsa. I’m not trying to outdo my student loan, but if I can just keep pace, I’m ahead because of additional liquidity.
Agree! Sometimes people go too hard at debt repayment and leave nothing for savings.
I always say, it’s really easy to move savings onto debt repayment but it’s impossible to move early debt payments into savings.
Liquidity is a major perk.
I just wrote the sentence wrong — fixed it now so it reads you’ll get out of debt in 63 months which is nearly 5 years early (shaves 4.8 years off your debt repayment schedule!)
Excellent post! I didn’t pay off my $27,000 student debt in a media worthy amount of time but I did knock it down from the 9 years it would’ve taken paying the minimum payments to 4 years. I did exactly what you describe here, checking how many months I took off by putting a little extra towards it. It was a huge motivator to get my debt paid off fast while still allocating money to “live”.
That’s amazing!!! Shaving 5 years off your debt repayment journey is no small feat!
I think we give too much attention to the people that pay off their debt in record time instead of celebrating everyone who makes major progress against their debts.
5 years is 5 years!! That’s a big deal!
Paying off debt is never a wrong choice. However, there may be better ways to allocate even those small amounts of money, especially if interest rates are more like 2-3%. This is the choice I made (and am still making) in general, although I did typically pay a bit extra.
Good point. I would add that it also depends on what the debt is for and the opportunity cost of paying down debt. For instance, if I have a mortgage on an investment property at 4%, which is better, paying down that 4% loan (that’s tax deductible, anyway, so effectively more like 3%), or putting the extra capital into another investment that will earn me 10%+ (perhaps closer to 8% after tax)? By paying debt off early, I’m costing myself between 5-6% depending on taxes.
Great read as usual. I am very much hustling to pay off my debt and can already see the benefits: My interest payments are much lower and the weight on my shoulders feels lighter.
While I agree with the argument in the post, I think we have to concede that people have different levels of risk aversion and tolerance for debt. For someone like me, who is a type-A worrier and very risk averse, I would, of course, prefer to hustle and save that extra 1300 for something else. But if someone has a stable job, good pension, and paid vacation, maybe they’re willing to forgo the 1,300 for greater immediate happiness: nice restaurants, a trip, or even topping up the TFSA.
Every time I come here I end up throwing more money at my student loan haha.
bahahahaha then I am doing my job!
I’m so glad that I got this message from you and other bloggers because it literally saved me thousands of dollars and now I’m debt free and saving for retirement and other goals. I had some savings to start me off which helped a bunch, but I put every extra dollar I could towards my student loan and got rid of it in a year. I ended up paying about 1,400 in interest instead of over 10,000 had I stuck to the scheduled ten year repayment. Made a huge difference! Paying extra helps so much, it’s just short term pain for long term gain.
I borrowed on my HELOC to buy my car off lease last year, and I’m paying off the loan as fast as I possibly can. I have about $3,000 left and I’m planning to have it repaid by year’s end. I hate paying interest after all :).
I found that students sometimes had so much hatred for school, they put off the payments thinking the school doesn’t deserve them, whether that is the case or not though, you will need to pay these eventually and the longer you take, the more you will pay. It’s too bad more students are not financially experienced to know this. Thanks for helping those who do there research!
This is a great post. I especially loved the comment that no one makes a big deal if you take 7 years to pay off a 10 year loan. Any early repayment is a win because like you said it is real money. The money comes off at the end which is extra money in saved interest but the bill is gone early. It’s a win-win. This is great perspective Bridget. Thanks for sharing!
I completely agree with everything here! I’m trying to aggressively pay down my student loans and have gotten them down around 10k in 10 months. While I could definitely put some of that extra money I’m putting toward debt into savings and investments, I think there’s a lot to be said about your mental health when it comes to debt. While it’s tough and a stretch on my budget some months, knowing that I’ll be free from debt sooner rather than later and have full control of my money is hugely motivating.
In the case of student loans, you might want to hold onto that debt for as long as possible and let it grow though. Anyone working as a resident for a nonprofit hospital could make the income based payments for four years, then do a fellowship for two or three years, then only need another three to four years working at a 501c3 to have their debt eliminated tax free. The PSLF program is a major reason why carrying student loan debt might be incredibly smart.
This isn’t an option for Canadians.
Bridget – I completely agree with what you have said & written in this post. I was in the same boat like many other Canadians. Had borrowed almost 16K in auto loan last year; to be paid off in 5 years.
However every month I would see 290$ bleeding out of my wallet. I followed the kind of advise that you have given. Got an extra payment in December, paid that whole chunk out; then received a hefty bonus, paid that whole amount as well and then received a decent sum from my income tax refund. Paid that amount too and closed the loan.
I could not believe it myself that I closed a 5 year loan in a year’s time. My original target was 3 years but boy I was glad to stop this bleeding of 290$ off my wallet.
BTW- I have also subscribed the investment course on MAG site. Is it possible that you take one complete amount of 379 USD as opposed to 3 installments as it saves me from currency fluctuation.
Let me know.
Sandeep
I need to keep your columns bookmarked and skim them before every impulse purchase.
Such great advice. I’m paying extra into my mortgage every month for exactly this reason! I hate to see the bank get all that extra money.
Why aren’t we holding mandatory personal finance classes at the high school level?! I’m heartbroken about all the kids who graduate and still don’t understand a lick of basic personal finance and compound interest and the weight of loans and credit.
In general? Yes. You are getting a fixed return. There are exceptions though, the so called “good” debt (aka debt that is deducatible, student loans for most people and mortgages) complicates a straight forward analysis. That and the relative interest rate from that computation and the absolute rate (for example, my mortgage is at 3.25%, when you toss in the marginal rate I pay it becomes 2.1%). And whether there is a fixed asset associated with it (mortgage). For example if I pay down my mortgage I then effectively have that money in an fixed, non-liquid asset that historically has underperformed compared to stocks and bonds (even if I toss in the rate above as part of the return it still comes out poorly).
But again, everyone has different risk tolerances and all situations are different (what works out for me may not work out for your particular numbers).
And I say this as I am actually paying some extra in, as I just refi’d and am slowly paying back in the money I got from escrow and the skipped payments, at least until the number/payoff date matches my previous loan.
We paid off all our debt, including our mortgage, very early. Completely debt free by 32. But now we are going the other direction and leveraging up, taking out a cash out refi on our primary residence.
Debt is tricky but you’re right to point out the behavioral aspect of it. We need rewards, and at the right time.
Great article! You hit the nail on the head with the savings/benefits of paying off your debt early. One thing that you mentioned at the beginning of the article is very true, you don’t feel the benefit of paying off your debt until the outstanding balance is $0. And yes, paying debt early accelerates this and you will hit that $0 balance a lot sooner. Since I love investing, I have to think of the benefit in terms of investing. In your example, if you pay ahead and realize your last payment significantly sooner, you can begin investing the $106 monthly payment into a nice dividend stock. So not only are you saving on interest, you are able to use the $106 that was going towards reducing the debt and turning it into an income producing asset. You are not longer paying a 5% interest rate and are instead earning a yield on average of 3.5%. Talk about turning that upside down!
Thanks for taking the time to write this article and draw out the example!
Bert, One of the Dividend Diplomats.
I have to admit, it frustrates me to read people who continually think ‘I will make more money by keeping my debt and investing that money elsewhere’.
Bull.
Sure, you may make money some months, but remember, YOUR DEBT MAKES MONEY OFF YOU EVERY MONTH.
Cash is king.
What you can’t control is what the market is going to do. What are interest rates going to do. Will the economy still have a job for you if it goes into a down turn.
What you can control is whether or not you owe anybody money.
At 40, I have been debt free for 6 years, including no mortgage on my home (yes, a mortgage IS STILL A DEBT). In doing so, the amount of liquid cash I have accrued to make some serious investments is significant. Further to that, I have no fear of losing my job or my spouse losing her job… We will easily survive.
Not having debt – of any kind – is very liberating. You may not realize how free it makes you feel until you achieve it. I’d equate it to somebody who was blind from birth and suddenly being able to see… For many people, debt is normal, but you have no idea what you’re missing by being debt free.
Besides being a financial gain, it is an emotional boost for so many of us. Having one last thing over our heads is psychologically freeing.
Well said. Being aggressive with attacking student loan debt (or any debt) is no picnic, but there are lots of awards in the end for doing it. Those numbers you provided as examples really do have a tangible benefits of having more money in your pocket at the end of it all
“In our $10,000 loan example, one extra payment of $75 at the beginning of the repayment term will knock 1 month off the loan term at the end. This means you’re essentially getting $106 worth for $75 — a $31 difference, or a 41% return on your investment.”
I like the article and agree with the general conclusion, but the math is being too simplified here. If you pay an extra $x on top of the required payment on your 5% loan, your rate of return is… Wait for it… 5%, not 41% (let’s ignore tax deductibility on any interest incurred).
Also, while it may only take a prepayment of $75 in month one to wipe a month off the life of the loan, month two will cost more. Follow the logic until you have only one month remaining: the last month will start with a principal balance of nearly the required payment ($106), which you cannot prepay with $75. Any prepayment is still yielding a 5% return to the borrower, but the nominal return is much lower due to having little time for that 5% to compound.
…and to add to your point about people saying it’s better to invest spare cash in the market (say at 8% returns) instead of prepaying debt at 5%, you have to factor risk (volatility) into that analysis. A 5% return from prepaying debt is risk free, while the market might yield 8% on average, but that includes years with huge corrections.