Wiping out the debt

January 11, 2007 10:04 PM

Is it better to pay off all my debts, or keep the debts and invest the money I would have paid them off with?

We're in a fair bit of debt. Nothing that we haven't been paying off - in fact we've never missed a payment - but it is a bit of a struggle to keep ahead. These debts include;

- A car loan
- Credit card
- Personal loan
- Laptop on hire-purchase
- A couple of other things; store cards, a stove on 12-months interest free

We've decided to sell our house - we don't live in it, I had to move cities for work, and the house we own is currently being rented out, and we are renting in our new city (at great cost). We are also losing money on the house we own, as our mortgage + council rates exceeds the rent we receive for it.

The profit we expect to get from selling our house will probably quite nicely pay off all our debts. This will leave us with no savings, but also no debt. The credit card can be stashed in the bottom drawer for emergencies.

The alternative is to keep servicing our debts, and put the profit from selling our house in some kind of investment, so when we want to buy a house some time in the future, when we've settled down at a permanent location, we will have a deposit.

Now intuitively, it seems to be the best idea is to pay off our debts, and start from scratch. After all, the interest we pay on our loans is greater than the interest we would earn if we invested the money. But is there something I'm missing? Are there any downsides, in my late 20s, to wiping the slate clean and starting with nothing? Will paying off all our loans actually negatively affect my credit rating? This might be a stupid thought, but if lenders can see that we paid off all our debts early, without making much profit for them, maybe they'll think twice about loaning me money in the future. Thoughts?

posted by Jimbob to work & money (24 comments total)

Definately pay off your credit card debt unless you have something like a 0% promotional period.

I would also suggest paying off the car loan since you're probably paying pretty good interest on it.

Your credit rating is largely based on your debt compared to your available credit. So paying off your debt will help your rating. Keep your credit cards active (but with no balance)though because long standing credit accounts will help your score.

You basically got it right in your question, pay it off if you're not going to be able to make a good bit more through savings interest.

Remember to keep enough liquid funds for emergencies though.
posted by aznhalf at 10:10 PM on January 11, 2007

After all, the interest we pay on our loans is greater than the interest we would earn if we invested the money.

That's really the main consideration, but I second the above suggestion to keep a rainy-day fund in a safe account (six months or so take-home pay if you can swing it, but if you're both working you could probably start out with less and budget contributions over time.)

This is probably obvious, but be sure you understand the tax implications before making any big decisions. I don't know anything about the tax code in your neck of the woods, but be sure you'll have enough left after you pay down your debts to cover any gains tax you might be liable for as a result of the sale.
posted by Opposite George at 10:26 PM on January 11, 2007

We were where you are. Different circumstances, same bottom line. We wiped clean. To keep our credit card ratings good, we did all our monthly purchases (bills, groceries, gas, etc.) on credit card and then paid the entire balance every month so no interest hit.
posted by kch at 10:26 PM on January 11, 2007

Generally, the only reason to borrow and invest is if the money borrowed is at a lower rate than you'll make investing it. Mortgage rates in the US, for instance, hit historic lows not too long ago; when compared to the rate of inflation, in fact, they were the lowest since the creation of the mortgage. That was literally the cheapest money ever made available to consumers, so borrowing and investing might not have been such a bad idea. It's more expensive now, though.

As long as you have some credit cards for emergencies, paying everything off is probably a good idea. Then take all the money you WERE spending on loans, and save it instead. Don't even think about using that money for consumption until you have at least six months' living expenses in the bank. Once you're that far along, get rid of any credit cards with annual fees; keep only the free ones. Treat yourself to something nice, but keep saving like crazy. And talk to a financial planner once you get to that point, because once you have your six month cash reserve, you'll want to start diversifying.

If you don't have much available on credit cards for emergencies, you might want to not pay off everything immediately; pay off your expensive debts first until you're down to 1 or 2 months' cash, and then repay the rest as quickly as you can.
posted by Malor at 10:29 PM on January 11, 2007 [1 favorite]

Regarding tax, we've checked it out, and we won't have to pay capital gains tax on the profits from the sale.

kch, regarding paying for everything on the credit card then paying off the entire balance every month. We did try to do this for a while, but unfortunately, the purchases we made slowly began to exceed the amount we were able to pay off it (mainly due to a new baby coming along), and we were quickly back up to the situation where we are now. We would prefer to pay off the credit card and then simply tryto not use it and live without credit, except for "emergencies" - what are the implications of this? You say you kept using your credit card to keep your credit ratings good - will my credit rating suffer if I keep the card with $0 on it?
posted by Jimbob at 10:33 PM on January 11, 2007

"We would prefer to pay off the credit card and then simply tryto not use it and live without credit, except for "emergencies" - what are the implications of this? You say you kept using your credit card to keep your credit ratings good - will my credit rating suffer if I keep the card with $0 on it?"

It really won't hurt it too significantly. Maybe have a monthly bill charged to it (something small) and then set up an autopayment on the account. You just don't want the bank to pull your card because its inactive(which I've heard can actually lower your rating).

But that aside there is the fact that you're missing out on the 1% (min.) of cashback that you can get with almost any card. Though if just keeping it locked away helps you realize your finicial goals 1% is a pretty small price to pay.
posted by aznhalf at 10:40 PM on January 11, 2007

Well assuming that all the debits you owe have higher interest rates than your money could earn in savings, then I suggest you pay them all off, except the 0% appliance loan. If this leaves enough for a 6 months wages buffer, then awesome. If not, then keep the buffer, and pay off as mich as you can, choosing the lowest interest loan as the one you keep, in exchange for the buffer savings.

In answer to the follow-up credit card question, I found the best answer for me was to get a charge card (Amex in my case), since it forces me not to carry a balance. Cut up the credit card, but keep the account open. If you ever really really need the credit card you can call ina nd say you lost it, and they will send you a new one. But don't.
posted by Joh at 11:40 PM on January 11, 2007

Another trick with credit cards is to freeze them in a block of ice. If you really need it, you can get to it, but it takes awhile and makes you think a few times about using it.
posted by Malor at 12:19 AM on January 12, 2007 [1 favorite]

Don't stick your credit card in the microwave to defrost, though, because it will likely demagnetize and/or melt.
posted by anarcation at 1:00 AM on January 12, 2007 [1 favorite]

If you're still in Australia; bear in mind that credit 'ratings' seem to be treated pretty differently here. I don't know much about it, but here's an example.
posted by jacalata at 1:41 AM on January 12, 2007

If you get a Visa debit card (just about any credit union will help you with this) you can use it like it was a credit card operating at the rate of interest of your cheapest current loan.

Pay off all your debts except $your_chosen_credit_limit worth of your cheapest loan, then park $your_chosen_credit_limit in a savings account attached to your debit card. Continue to service that loan at the present rate, treat the savings account as if $your_chosen_credit_limit is actually zero, and pretend your debit card is a credit card.

If you like, you can send yourself a monthly bill :-)

I do this with my mortgage. Once I'd made the shift from Highly Paid City-Dwelling Software Developer to Relaxed Part-Time Country Technician, my income became very small and I started having trouble juggling everything to get bills paid without undue delay. So I redrew $1000 from my mortgage and stuffed it in my savings account. Now I behave as if any time my savings account has less than $1000 in it, I'm in the red and I need to rein in my spending; I always mentally subtract $1000 from whatever my actual balance is.

This means I can set up auto-payments for regular bills, and use BPay for irregulars, and still be confident that I won't have to deal with the embarrassing business of facing a refused transaction for the $50 worth of diesel I've just pumped into the ute. I can also treat pay-cheques as if they cleared instantly instead of waiting the irritating five working days for my spending power. Because the money came out of a low-interest mortgage, my $1000 "credit limit" only costs me about $75/year.

If you're smarter than me, you'll find an online-only bank that actually pays more than a nominal rate of interest on small amounts of savings. Your "credit card" rate then basically becomes the difference between your cheap-loan interest rate and your savings-account rate.
posted by flabdablet at 2:10 AM on January 12, 2007 [1 favorite]

I've had the same thoughts on paying off vs. investing. As pretty much everyone has noted, most investments won't return an interest rate equivalent to what the interest from debt incurs. But what if you apply the profits from sale towards a 401K or a Roth IRA?

I'm around the same age as the poster, so 45 years or so until retirement means a lot of compounding. In which case, would this be a better investment, if hypothetically I/he sticks to paying off the minimum monthly plus extra on all outstanding debts, and can conceivably pay everything off in 3-5 years?
posted by krippledkonscious at 2:51 AM on January 12, 2007

A short, punchy answer: paying down debt is equivalent to an investment at that debt's interest rate for the period you would otherwise have carried the debt. Consider the relative rates of return and timescales involved, and allocate your debt payments and investments accordingly.

For some people, this perspective makes paying down credit cards a 29.99% investment compounding for 10 years (or, sadly, far longer)!
posted by onshi at 4:40 AM on January 12, 2007

Paying off debts will help your credit score but I would leave the total amount small enough so that you don't pay ungodly amounts in interest.
posted by JJ86 at 5:57 AM on January 12, 2007

Considering all the interest you most likely paying, I would say that it would be a better idea to pay off the debt instead of investing it. Carrying high balances on credit cards hurts your debt, not paying them off. If you would still want to invest something or build up savings, I would say to take the money you would have normally used to pay your debt and invest that. Keep the same standard of living and just put the money into a savings account or a 401k.
posted by Attackpanda at 6:51 AM on January 12, 2007

I would invest the money that you get from the house. Yes, it will be difficult to obtain a return higher than the interest you are paying on your debts, but you will actually acquire some savings. If you just pay off the old debts you will probably just find ways to spend the extra income you get from not having to make payments on those debts. If you are disciplined enough to put them into savings rather than spend them then do it, but otherwise I think you will be better off in the long term by investing the house money and continuing to whittle away at your other debts. By invest I mean putting it into something that pays well and which is less convenient to lquidate than a bank balance. Conventional wisdom says go for the highest return either in an investment paying more than your current rates on debts or by paying down the high interest debt. However, if that won't lead to savings but instead just leads to more spending then it doesn't seem so wise to me. It all depends upon your discipline, which most of us find a bit lacking in these matters. If you do decide to pay off the debt, I suggest that you find one or more mutual funds or some other investment into which you can automatically have deposited a set amount from your checking account every month, that amount being at least as large as your current debt service.
posted by caddis at 7:27 AM on January 12, 2007

Attack debt first, invest later.
posted by Ironmouth at 7:27 AM on January 12, 2007

Don't get too caught up in the clean sweep mentality, though. You should able to pretty easily realize 5-7% returns on reasonably low-risk investments, so unless you feel uncertain about the future financially, there's no need to pay off anything that is earning less than that.

I do think there are some benefits into getting into a savings/investing mentality, even if in the short term it is not the numerically best allocation of money - starting with a nice balance can act as an incentive for sticking to a savings program.

Still, of course do the math on everything individually. Some of your debts (I'd guess store cards, for instance) are probably no-brainers at 2 digit interest rates. That personal loan and the laptop deal, all depends on the terms and rates. The stove is probably a no-brainer too, if it is truly no interest with no financial benefit for early payment, leave it, no point losing that potential interest on the cash.
posted by nanojath at 9:21 AM on January 12, 2007

I'll echo the suggestion to focus on debts before savings and investments, but I do have a suggestion re: the order in which you tackle the debts:

Common sense would say to pay off the highest-rate balances first, but you mention that it's a struggle to stay on top of your payments.

If that's the case, you might do better to focus on paying off something with a consistent monthly payment (the car loan, for example) first. That will give you an extra chunk of money every month.

That extra money should be used mostly to pay off other debts more quickly, but it will give you a bit of breathing room for those months when unexpected expenses crop up.
posted by scottnic at 1:10 PM on January 12, 2007

Payoff the debts and force yourself to save money (automatic deposit of monies from payroll to savings account is a good idea).

Malor: I did the CC in block of ice as well. It took me all of about 3 seconds to remove the ice-encrutsted CC with a hammer in our kitchen sink.
posted by internal at 1:30 PM on January 12, 2007

internal: then you didn't use enough ice :)

If you cheat and use a hammer -- then use a block too big to hammer.

I'm not sure I'd really want to do it that way, anyway. My freezer is pretty cold, and I'd be worried that I'd break the plastic. Hot water takes awhile, but it's safer.

Regardless: you didn't have it with you when you saw something shiny. You had to take special action to get to it. Just that sanity check alone may be enough to snap you out of an acquisitive daze. :)
posted by Malor at 1:44 PM on January 12, 2007

Always always always get rid of debt first. Eliminating debt is the highest, largest and by far the best investment you'll ever encounter. There is no possible investment that could ever be greater than tackling debt first. That said, pay the debt off first.

Make a simple budget of debts -- a list of everything you owe money to, and a list of income sources. Make a list of things you currently must pay (like food/water) and another of what I call iffies (non-essentials like cable/satellite but are under a contract that if you were to quit you'd have to pay a penalty). See what you've got left over. Seriously consider cancelling non-essential services like cable TV that aren't on a contract. It'll help getting rid of that debt like wildfire. Break up what's left over and spread it out over each of the debts -- but put greater emphasis on the smaller amounts.

Wage whether having to pay a penalty for cancellation might increase your available income to spend on getting rid of debt, versus keeping it and paying it out (may be cheaper to keep it, such as if you've only got a few months left in a contract). If the cancellation penalty is smaller than the contract amount, seriously consider cancelling the service until your debt is out of the way. You really need to get that debt out quick, moreso that you think you "really" need cable TV.

Once you've got a list of available income to spend on eliminating debt, make a magic, unchanging number that will always go to eliminating those debts that you will use every month.. and take into account for real-emergency purposes (not like emergency milkshakes) that this number will not change.

Allocate enough funds to each debt to meet the minimums -- but start out putting greater emphasis on killing smaller debts first -- because when that smaller debt is eventually eliminated, your mgic number remains the same. DO NOT fall for the trap that once you've got a debt eliminated, you can use the money you spent getting rid of it each month to buy more stuff. The magic number stays the same. Shift that "new" amount of available debt-killer funds to the next smallest debt and concentrate on getting that one obliterated. Now you're accumulating greater and greater power to eliminate debt each month, while still spending the same amount. Only after you've annihilated the massive debts, can you start using the money from the magic number to buy other stuff.

If you get a bonus at work, use it without hesitation to get a lesser debt cleared. The bonus is an opportunity to become closer to getting out of debt, not an opportunity to rack up more.

Getting out of major debts should be an absurdly dilligent priority as far as a household budget goes.
posted by Quarter Pincher at 8:52 PM on January 12, 2007

Always always always get rid of debt first. Eliminating debt is the highest, largest and by far the best investment you'll ever encounter. There is no possible investment that could ever be greater than tackling debt first. That said, pay the debt off first.

That advice is so wrong. How do you think guys like Trump made their money? If he paid off the debt first he'd be living on chump change. Leverage to make money is the key to capitalism. "Always" is a strong word, and you just abused the hell of it.

Even if not taking on investment debt you should examine what will provide you with the best situation in the end. Return is but one factor. If you are chronically in debt beyond your means, if you skid back toward that situation every time you make some progress, if debt hangs about you like a noose, then eliminating all debt and learning to live without credit is probably more important to you than anything else. That might be Jimbob's situation, but just because they have copious debt does not make the situation that dire.

As for return, it has been discussed endlessly here. If you have a known debt costing you 10% and an investment that might return 10% then cancel the debt, because the uncertaintly of the investment makes it worth less than 10%. For different percentages it can be difficult to decide where the lines cross but the idea itself is simple.

If your debt is credit card debt you are wise to play the game of transferring it to low or no interest credit cards as needed to keep your interest on it as low as possible. This may be a bit harder these days than in the past but remains doable. If you are paying a high interest rate on credit card debt you probably are not working the system hard enough.

If you are not consumed by debt and have zero savings I maintain that it is often better to put new found money into savings, and put it into something that takes an extra step to liquidate so that you are less likely to spend it. Having this cushion can be crucial to prevent bankruptcy or serious credit problems if you lose your job, develop serious health problems etc. It also helps get you started toward a regular savings program. Watching your savings grow often induces more savings.

Putting new found money into savings while continuing to whittle away at existing debt also forces you to live on less. If you have $1,000 income per month and pay $150 to service debt you are living on $850. If you get a big chunk of cash, pay off the debt and don't put anything into savings then you will simply start living off of $1,000 month, wasting the extra $150 on better beer etc. Frankly, most people probably fall into this catagory, I am not sure about Jimbob, only he can answer that one. However, most people can service their existing debt, but if it went away would fail to institute a proper replacement savings plan.

Common savings advice is to treat savings like any other monthly expense and pay yourself some percentage of your take home. The problem is that this one bill is optional whereas the rest really are not. The solution is to set up an automatic withdrawl from your paycheck or from your bank account which goes into long term investments, be it IRA, 401k, mutual funds, individual stock drip accounts, money market, or best some mixture of different investments.

What will be best for Jimbob? Well if he has chronic debt problems then elminating the debt and learning to live without credit is probably best. If on the other hand he just has been careless in attending to the debt but in the new job will having the means to attack the existing debt while still meeting the day to day expenses, including a few modest splurges, then it might be best to save some if not all of the money from the house. Of course any high interest debts that can not be refinanced at low interest rates should be paid off pronto. He can always decide later to pull the savings and squash the debt. The worst thing would be to just spend the money from the house to buy new things or pay current expenses while leaving the existing debt. Probably most people would say that they would never do that, but probably most people would in fact do just that, perhaps not all in one fell swoop. Whatever is done, discipline in financial affairs matters. Since most people are not robots, and given the powerful use of advertising to overcome our discipline, it pays to set up systems whereby you pay yourself and your debts first, and then spend on luxuries later.

Don't forget to budget for a few luxuries. Failing to do this will often lead to new debt. You will feel so overwhelmed by the frugal lifestyle that one day you will find yourself the proud new ownere of a 50 inch plasma tv, no money down. Oops. Put a little money into a special account for such splurges so you don't have to put them on the credit card.
posted by caddis at 4:56 AM on January 13, 2007

We have, in the past, been quite good at saving "when we have to". Before we had all this debt, we saved to pay for our wedding, saved for a number of holidays etc. so my wife and I are reasonably confidant that if clearing our debt leaves us with a bit "extra" cash each week, we will be able to save it rather than spend it. And, as you suggest, we're considering a direct debit system to make sure that money goes to savings.

I should note that my wife, when she was working, had a system of paying extra income tax each week. No, no, libertarians, stay with me, take your fingers out of your ears. It was her way of ensuring (a) she never had a tax bill; no matter what happened she was bound to get a return, and (b) there wasn't no way of getting that money back until tax return time. So saving, in one way or another, should be an option for that.

If your debt is credit card debt you are wise to play the game of transferring it to low or no interest credit cards as needed to keep your interest on it as low as possible.

Part of our reasoning for selling the house and paying off the debt is just to simplfy things, above and beyond the financial implications of debt and interest. We've just got to many damn accounts and loans and insurance policies, and it causes me stress just thinking about it all. For this reason, going through the whole process of transferring my balance to some new company, then keeping track of when that balance is going to tick over into "interest" territory, knowing that the debt is still there, is still unnecessarily complicated to me. I'm just sick of it; I long for a return to the days when you took real, live cash out of your bank account, and used real, live, cash to do your shopping, and that's as complicated as managing my money got. I guess I just don't want any accounts active, apart from the bare, absolute essentials.
posted by Jimbob at 3:17 PM on January 13, 2007