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For the last 2 years, I have been trying hard to be debt free without affecting my personal cash flow. I am by no means a rich person, but I have a decent salary.

I still have debt, specifically

  • Education Loans (Interest 3%)
  • Car Loan (Interest 4.75%)
  • Less than 3K in personal loans

Is it smart to work towards be 100% debt free, or is having some debt for some reason smart?

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17  
I would not say that 4.75% is a very low interest... –  snowflake Mar 3 '11 at 13:53
    
You are right, is not very low, I found a 3.25% and I am changing my loan to that. Either way, my goal is to get rid of it soon. –  Geo Mar 3 '11 at 14:30
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Lower than a lot of sovereigns are paying ;) –  poolie Jan 27 '12 at 9:10
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Can I lend you some money for 4.75%? :-D –  user4929 Mar 22 '12 at 4:29
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@user4929, are you ready to handle the default risk? –  dainichi Jul 24 at 7:14

16 Answers 16

up vote 91 down vote accepted

If you can borrow for an asset that gives you income that's more than the cost of carrying the debt, then go for it.

But the kinds of debts you have now aren't those kinds of debt, so get rid of them.

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I would argue that the education loan, assuming that it is a degree that will get you a decent job, is "borrowing for an asset that goves you income". For the other two, I agree with you. –  KeithB Sep 26 '10 at 2:01
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If you could buy a rental house, and all of your expenses, including the interest on the mortgage, were, say $500/month, and you could rent for $700/month, then that would be an example of the other kind of debt. –  mbhunter Sep 26 '10 at 20:06
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Other examples: borrowing to improve a house's energy efficiency, buying tools/equipment that will improve job performance, buying clothing that is needed for a job/promotion. –  duffbeer703 Sep 27 '10 at 3:37
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I really would question the wisdom of keeping or discarding a loan based upon the costs of carrying the loan. It is not an investment and I do not think it should be used as any kind of criteria. There are a lot more important factors which you can use as the basis for paying off a loan that have to do with your future. Simply carrying a loan for the sake of carrying a loan does not make any sense. Pay all of them off ASAP with the highest interest rate first. –  Ralph Winters Mar 28 '11 at 18:05
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@KeithB Borrowing to get an education is absolutely a good idea. But once you have the education, getting rid of the debt as soon as possible is also a good idea. –  DJClayworth Aug 19 '11 at 14:56

Debt increases your exposure to risk. What happens if you lose your job, or a major expense comes up and you have to make a hard decision about skipping a loan payment? Being debt free means you aren't paying money to the bank in interest, and that's money that can go into your pocket.

Debt can be a useful tool, however. It's all about what you do with the money you borrow. Will you be able to get something back that is worth more than the interest of the loan?

A good example is your education. How much more money will you make with a college degree? Is it more than you will be paying in interest over the life of the loan? Then it was probably worth it.

Instead of paying down your loans, can you invest that money into something with a better rate of rate of return than the interest rate of the loan? For example, why pay off your 3% student loan if you can invest in a stock with a 6% return? The money goes to better use if it is invested. (Note that most investments count as taxable income, so you have to factor taxes into your effective rate of return.)

The caveat to this is that most investments have at least some risk associated with them. (Stocks don't always go up.) You have to weigh this when deciding to invest vs pay down debts. Paying down the debt is more of a "sure thing".

Another thing to consider: If you have a long-term loan (several years), paying extra principal on a loan early on can turn into a huge savings over the life of the loan, due to power of compound interest. Extra payments on a mortgage or student loan can be a wise move. Just make sure you are paying down the principal, not the interest! (And check for early repayment penalties.)

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This answer is more comprehensive than the currently accepted one by mbhunter. It's important to talk about risk as well as potential profit. –  DJClayworth Jun 15 '11 at 18:01
    
+1, low debt = low risk –  John Pirie Jul 7 at 1:15

The responses here are excellent. I'd add just a couple points. Debt is not generic. It ranges from low (my HELOC is 2.5%) to insane (24% credit card, anyone?). When I read about the obsession to be completely debt free, I ask questions. Are you saving in your 401(k) at least up to the match? I disagree with the "debt is evil" people who advise to ignore retirement savings while paying off every last debt. My company offers a dollar for dollar match on the first 5% of income deposited. So a $60K earner will see a $3000 deposit doubled. 5 years of this, and he has 1/2 a year's income in his retirement account, more with positive returns. (note - for those so fearful of losses, all 401(k) accounts have to offer a fixed income, low risk choice. currently 1% or less, but the opposite of "I can lose it all".)

After that, paying off the higher debt is great. When it's time to hack away at student debt and mortgage, I am concerned that if it's at the risk of having no savings, I'd hold off. Consider - Two people in homes worth $250K. One has a mortgage of $250K and $100K in the bank. The other has his mortgage paid down to $150K. When they lose their jobs, the guy with the $100K in the bank has the funds to float himself through a period of unemployment as well as a house the bank is less likely to foreclose on. The guy with no money is in deep trouble, and the bank can sell his house for $150K and run away (after proper foreclosure proceedings of course.)

My mortgage is one bill, like any other, and only a bit more than my property tax. I don't lose sleep over it. It will be paid before I retire, and before my 11yr old is off to college. I don't think you stupid for paying your low interest debt at your own pace.

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Not even to mention levels of those debts available for those of us who are not in the US in Mexico a credit card with a 40% is not uncommon –  jclozano Dec 20 '11 at 4:28
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+1 for value of cash (i.e., liquidity) mentioned in answer. Ultimately, 'cash is king.' –  Jubbles Jul 9 at 4:54
    
24% credit card isn't close to insane compared to wonga.com 365% pa personal loan –  gerrytan Aug 15 at 4:10

You might miss an opportunity or three by strictly avoiding debt, but I can't think of a problem you will create by being debt free.

So maybe it isn't the absolutely smartest thing to avoid debt on principle*, but it certainly is pretty smart at the very least.

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*see what I did there? –  MrChrister Sep 25 '10 at 23:50
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+1 for cleverness :) –  bstpierre Sep 25 '10 at 23:53
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In that case, it doesn't matter whether you spell it principle or principal! –  mbhunter Sep 26 '10 at 0:00
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+1 for a financial homonym and double entendre. –  JoeTaxpayer Jun 10 '11 at 13:26
    
+1 this is a fantastic answer. People don't usually consider debt this way. Debt creates opportunity, while debt-free creates, well, freedom. –  Brandon Jul 24 at 1:52

Keep in mind that you NEED to have a cash reserve. Blindly applying all stray cash to debt reduction is a bad idea. Your lenders do not care about your balance. All they care about is your NEXT payment. It is therefore imperative that you have a cash reserve that can carry these payments for several months. Having zero cash reserves puts you at high risk for such simple things as the payroll clerk at work missing the monthly deposit (Rare, but it happens.)

I've also been in situations where a major client had a cash flow issue and delayed payment, and our company had to borrow to meet payroll that month. Fortunately, we were in good standing with the bank and had low debt, but it could have been catastrophic for any employees living paycheque to paycheque.

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+1 because the issue of cash reserves has been missing from the other answers here. –  Justin Ohms Jul 11 '11 at 16:53

No matter what, it is never a bad decision to go 100% debt free. However, you can make debt work in your favor in some cases (investments, education, etc.), but you need to approach it with a plan and long term strategy. Interest, fees, and loss of value can quickly eat up any gains.

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If you don't have any lines of credit for a long time, it can adversely affect your credit score. At least a credit card that is always paid off is useful if you ever need more credit. –  justkt Sep 26 '10 at 1:15
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@justkt Good point. A paid off every month CC type of setup would work great to maintain a credit rating if you would like to maybe use debt in the future. However, you don't need a credit score if you truly want to run 100% debt free. –  Troggy Sep 26 '10 at 1:21
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@Troggy With credit scores being used for setting insurance rates, renting apartments, and even to screen job applicants, I think everyone can benefit from having a decent score. And if you have the discipline to only charge what you can pay off each month, using a credit card doesn't imply having debt. –  KeithB Sep 26 '10 at 2:05
    
@KeithB I don't disagree with you at all. The no credit score idea is just one of those "point of view to think about" ideas of a pure 100% debt free no credit ideal. You can definitely be pro debt free without being totally anti-debt. –  Troggy Sep 26 '10 at 5:15
    
Great answer; short and to the point. –  mkchandler Oct 21 '10 at 16:25

I think about debt as a good option for capital investments that offer a return. In my opinion, a house and clothes you need for that new job are good things to borrow for. School is ok, depending on the amount. Car is ok, if it's a 3 year loan. The rest is not good.

You should try to carry as little debt as possible, but don't let it dominate your life. If faced between the choice of paying ahead on your student loan and blowing $300 on an XBox, you should pay the loan. If the choice is between taking your kid to the zoo and paying the loan, have fun at the zoo.

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+1 always budget in some fun. –  MrChrister Sep 27 '10 at 16:20
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My aunt, who is a divorce lawyer always talked clients down by saying "If you don't leave him enough for a case of beer and the occasional football game, He'll default on support" –  Chris Cudmore Mar 29 '11 at 14:27

When you're debt free everything you own feels different. The lack of financial stress in your life goes away.

BUT! before you do go gung-ho on paying down debt think through these steps (and no I did not come up with them. Dave Ramsey did and others).

  1. Save $1,000 (or whatever currency your country has) in a very fluid account - safe, cash, etc
  2. Snowball the debt payments. Smallest to largest. Once paid off take cash from that paid off debt and apply to the next one.
  3. Save 3-6 months of living expenses in a fluid account (not a CD or retirement account) where you can get it relatively quickly. Cable TV/Netflix/Xbox does not count towards living expenses :)
  4. Save 15% into Roth IRA, etc
  5. Save for college (kids)
  6. Pay off home early
  7. Build wealth and give.

Truncated from - http://www.daveramsey.com/new/baby-steps/

I have 1 credit card. Only use it for business/travel but pay it off every month (yay for auto-draft). Everthing else is cash/debit and we live by a budget. If it's not in the budget we don't buy it. Easy as pie. The hard part is disciplining yourself to wait. Our society is gear for BUY NOW! PAY LATER! and well you can see where that has taken our country and families.

And celebrate the small victories. Pay off 1 debt then go have a nice dinner. Things like that help keep you motivated and pursuing the end goal.

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The day I paid my last student loan payment and my last car payment was (January 4, 2000) a very happy day for me, being then 100% debt free. It is a very good feeling, especially since I was saving cash as well. It's a great thing to know that no-one "owns" you.

Many others here have provided useful information about debt, and I know that paying off your existing loans will improve your credit rating, in case you want to go back into debt (which I did later in 2000, by buying a house).

For most people, borrowing money to invest it is complicated (make sure you're not paying more on your borrowed $ than you make on your investment) due to the fact that most investments have risk involved.

I would say that being debt-free is a very good goal, and there's a level of freedom it gives you. Just make sure you have your "rainy day" fund building while you're on your way to getting there.

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100% debt free is an objective. Being there is good, but as long as you have a plan to get there, are sticking to it and it's moving you towards it at a reasonable rate (e.g. "I will be debt free by the end of 2011."), you should be in good shape. It's when you don't ever expect to be debt free that you have a problem.

Going into debt is one question and a very situation dependent one.

Getting back out is another and a very easy one: pay off all debts as a fast as you reasonably can, starting with the highest interest ones.


OTOH this doesn't imply that you should forgo every optional expense (including things like savings and entertainment) to pay off debts, that would be unreasonable, but just that paying down debts should always be considered when thinking about what to do with money.

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Would you run a marathon with ankle weights on? It starts off as ankle weights, but then grows into a ball and chain as you dig yourself a little deeper each time you use your credit card (and then don't payoff the balance because "something more important came up").

I would love for my wife to be able to be home and raise our son, but we simply can't afford to do that with the amount of debt we have. We are clawing our way out, and will pay off one student loan and a car loan, then start saving for a house and once we have that, we'll get back to debt reduction.

Get debt free. That's where we are headed. Most of it is student loans at this point, but debt will take away your freedom to do whatever you like down the line. It just increases your overhead in the long run.

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This is a "stress" period, much like the 1930s and 1970s. At a time like this, it is smart to be debt free, and to have money saved for the likely emergencies.

There are growth periods like those of the 1980s and 1990s, probably returning in the 2020s and 2030s. At such times, it makes sense to play it a little "looser" and borrow money for investments.

But the first order of business in answering this question is to look around you and figure out what is going on in the world (stress or growth).

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As others mentioned, the only clear reason to remain in debt is if you can find an investment that yields more than what you're paying to maintain the debt. This can happen if a debt was established during low-rate period and you're in a high-rate period (not what is happening now.)

A speculative reason to keep debt is as an inflation bet. If you believe money will shortly lose value, you are better off postponing repayment until the drop occurs. However you're not likely to be able to make these bets successfully.

Hope this helps

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A Simple Rule to discern between good and bad debt:

  • Good Debt: Someone else pays off for you (your tenants provide rental income applied to a mortgage, etc.)
  • Bad debt: You pay off (your credit cards, student loans, etc.)

Does this mean you should never buy a house or car? Of course not. But if you accrue bad debt, make sure that you can handle it and understand the costs and repercussions.

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Very smart. Let other people pay you interest. Don't pay other people interest. And, yes, I know it's possible to borrow money from one place and lend it to another place at a slightly higher rate, but why bother.

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Having no debt should be the ultimate goal for every household, IMHO, but at what cost?

As an example, I had some clients (before they started working with me) that had outstanding debt when they retired and were gung-ho to pay it off. They opted to take it out of their retirement accounts. They didn't set aside enough for taxes which was their first mistake.

After a few years, they now have realized they should not have paid off everything as now they have other medical issues that have arisen and not enough in their retirement accounts to satisfy their monthly requirement.

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