Spouse wants to pay all debt in a month but I don’t. Is this a good idea?

Question

Between both of our student loans and car loan, we are in the hole about $48,000. My spouse is adamant about paying off all debt in the next month or two since we currently have about $55,000 in the bank. The issue is that I don’t see why we need to pay off everything so quickly and basically drain our account.

Our monthly take home net income is about $8,500 a month and after all bills are paid, we have about $4,300 left to save or do whatever we want. Our school loans and car loan use up a little over $1,000 dollars of our monthly income.

The way I see it, the amount that we are paying for those loans isn’t really hurting us. We are still saving a good amount and don’t see the rush to use up most of our money to eliminate these loans. My spouse claims that it’s alright because we will be able to recover fairly quickly because of the extra grand we would now have.

But what about emergencies? Or something that requires us to spend a large unexpected amount of money? Doing it their way would leave us with about $7,000 in the bank and it just seems like such an extreme to pay so much off so fast. Would paying off all this debt this fast be more beneficial than I’m thinking? I want to keep an open mind before really deciding what to do.

Car loan has about 3% interest and $8,000 left on it. There are 3 school loans, all at about 4-6% interest rate. One is at $13,000, the other at around $3,000 and one big one at around $24,000.

Answer 1

Split the difference. Keep $30K in the bank and pay $25K of loans now. Use your $4,300/month to pay the remainder of the loans over the next 6 months, and then use the following 6 months to replenish your bank account to $55K (if that is the amount you feel like you need liquid for emergencies).

By paying some of the loans now, you demonstrate to your spouse that you are serious about paying them off quickly. This is a compromise that should satisfy most of the needs expressed in your post.

Answer 2

If your interest on those loans accumulates monthly, it's cheaper to pay them off now (unless the interest rate is below what your money earns you in the savings), though I would make sure I have enough money socked away for an emergency($2k-$5k plus a couple months expenses minimum). If the interest was assessed at the onset of the loan, and early payback won't reduce it, then let the debt ride for as long as you have comfortable disposable income beyond your monthly expenses, seeing as $55k is likely enough for emergencies.

If you do pay back the loans early, check to see if there is an early payback penalty, and if that penalty wipes out the savings from paying it back early.

Another thing I would caution against: If you're considering retirement money in that $55k, don't. The cost of withdrawing from a retirement account, even if it's on a plan-approved loan, is very high.

Answer 3

Look at how much interest keeping that amount in cash is costing you. At 5% interest, that's $200 a month wasted in interest payments just for the peace of mind of having cash in the bank.

I agree with your wife. Pay the debt, start saving and/or investing again and that $48k will be built back up in less time that it would have taken you to pay it off a little at a time. It also gives you the flexibility to look at tax advantaged savings (retirement) that will benefit you more in the long run.

If you decide you don't like it, you can always get another loan to put the cash back in the bank.

What kind of "large expense" are you anticipating? Do you not have health and car insurance that would cover you in case of expensive accidents? The only thing I can think of that you would need to save that much money for is a down payment on a house, and I would recommend paying down the debt before doing that anyways.

Answer 4

Unless

1. You plan on investing that cash in a way that will bring you higher returns

or

2. You really believe you will need that money for an emergency

You should pay it off. Stopping the paying of interest rates will save you money in the long term. Hoarding it in savings will lose you money in the long term.

Plus, it feels really, really, really good to pay off your school and other outstanding loans. I suspect that is what your spouse wants.

Answer 5

You're both right! I agree with your spouse's inclination to stop paying interest when you have the money sitting in the bank. I also agree with your trepidation of paying it all off due to a possible emergency.

One way to achieve the best of both worlds is with a line of credit. If you have a decent credit score and $55K sitting in the bank, there is a very good chance your bank will give you a line for at least $20K. Then you can feel at ease paying off all your debt right now, since in case of an emergency you could access some of the line, and if you don't have an emergency (which is the likely scenario) then you benefit by avoided paying another dime of interest.

Answer 6

Paying loans is exactly like making a limited-term investment with very low risk. If you have a 4% APR loan, by paying it off early you will avoid paying interest (assuming your contract allows it) so it is as if you invested the amount you repaid into a business that returned 4% every year. Actually your gain could be a bit more than the 4%, because paying off your loans could improve your credit score and potentially result in lower fees and interest on any new loans you take out.

Then the question of whether to payoff the loan has exactly the same concerns as any investment:

1. Is the return worth it?
   • Your 3% is maybe on the low end, but 6% is quite respectable. But to be sure, either is better than a typical bank deposit, which might return something like 1-2%.
   • You should be subtracting inflation from your expected returns.
2. Does it return more than other things you could invest in?
   • Stocks are said to return 7%, but of course that is much more variable and risky.
   • When comparing, keep in mind that the "income" from paying loans early is not taxed, unlike most investments. So paying a 4% loan is technically better than investing in a business with 4.1% return, because you would pay tax on one but not the other.
3. Is it riskier than other investments?
   • There's not much risk in repaying loans, but there is a big one: There could be some extraordinary circumstance that would discharge the loan without you having to repay it in full. If you've already paid off your loan by the time this happens, you could miss out on the "free money" that essentially comes from someone else footing the bill for your debt.
   • Conversely, holding cash also has risks: It could get stolen, for instance.
4. Opportunity cost - are you likely to need the liquid funds for an emergency?
   • Unlike traditional investments, you can't simply "sell off" a loan you already paid off. But if you were creditworthy enough to get the loans back then, chances are that after paying them off you will be equally creditworthy so you could easily borrow money again to cover any unexpected emergencies. It is up to you to make sure the loans you could get now have terms as good or better than the ones you currently owe - for instance, student loan interests tend to be very good due to government regulation (yours seems a bit high, though), and you're unlikely to get as good a loan without going to school again.
   • Alternatively, you can try to pay off the loan and buy insurance against the "emergencies". The money you lose on premiums will be comparable to the interest you'd be saving from the loan, but depending on your specific situation you might come out with a small net loss or gain.
   • Having the loan also has an opportunity cost: It could make it harder to get a mortgage or a car loan for instance. But chances are you wouldn't suddenly need to buy a mortgaged house right away, so you could just hold on to the money and pay off your loan if and when the mortgage problem actually happens (it might not).

By looking at these 4 points, and investigating alternatives, you can decide for yourself if you should pay them off or not pay them off. In your case, the interest rates seem a bit high, so I'd look into refinancing for a lower rate or maybe even pay it off.

"On average", a person who has cash on hand exceeding their debts and is using that cash for something productive (either investment or even spending on something they need/want) is not much better or worse off - that's why the bank sets the interest rate at exactly the number it does. But if you're just letting that money sit under your pillow gathering dust, you are the bottom of that average. Borrowing money is like renting it, and paying rent on something you don't use means that rent (=interest payment) is going to waste.

Answer 7

I'll suggest a compromise: Don't pay back all the loans in one go. Pick the one with the highest interest, and pay off say $6,000 every month (pay back in eight months) or $4,800 every month (pay back in ten months). As much as you can from your monthly income, and the rest from your savings.

Your spouse will be pleased that the debt goes away very quickly. On the other hand, you won't use too much from your savings, and when everything is paid back, you will be able to replenish your savings very quickly. On the third hand, if you pay back the loans with the higest interest rate first, your interest payments should go down every month. If you just pay back $6,000 on a 6% loan, that's already $30 you save every month. And that's just from one payment.

If you only have loans left where the interest rate is lower than your saving account's interest rate, then maybe reduce the repayments.

Answer 8

Provided that:

• You aren't locked into paying the full amount of interest, or otherwise penalized for paying it off early
• You leave enough of a cushion to cover a short-term emergency (anywhere from $1000 to 6 months of minimal living expenses)

...then paying off as much as possible, as soon as possible, may or may not be optimal, in terms of the fastest theoretical growth of your wealth, but it's definitely safe. If you invested that money, you'd likely see returns greater than your interest rates, but you have be willing to accept considerably greater risk than paying it off now.

I don't think there's a single right answer here. It really comes down to you, and your spouse's personal tolerance for risk. If having a loan looming over your heads, or the possibility that the market could take a dive, or you lose your job, or some other emergency, and you might be forced to sell low to keep up with payments, is likely to cost you some sleep, then maybe lean toward repayment. If that doesn't bother you too much, then keep up with your payments and invest the rest.

For what it's worth, I would personally lean toward repaying sooner. But that's me. And that has far less to do with concern about a market crash, and far more to do with valuing the ability to walk away from a job if I need to without being concerned about keeping up with loan payments.

Answer 9

If your earnings are $8500 and surplus is $4200, your burn rate is $4300. Assuming you could belt-tighten at down to $3500, an 8-month emergency fund is $28,000. Done.

Then I'd make sure my 401Ks and IRAs are maxed out, at least to the degree that makes sense to you. These are special trust accounts which are immune to lawsuits, because they are a trust-fund for a purpose: funding your retirement. Fund these first because people chasing you for consumer debt can't go after your 401K, so you will have paid yourself instead of them. Finally the debt.

As far as the loan priority, student loans are weird. They can't ever be discharged in bankruptcy unlike every other loan. But they also have lots of programs for deferring them. If they are Federal loans, they are even easier to deal with if you can't pay them right now. This makes them fairly magical. A Federal student loan is the last thing I would pay off. Seriously.

Private secured consumer debt (car loan) first - get it out of hock. Then other private unsecured consumer debt (credit cards). Then private student loans.

For loans in the same "tier", pay them off in interest rate order. Some people argue to pay the smallest one first, because they feel the "warm fuzzies" of having Knocked One Out will help keep you motivated. That's not really a problem you have, though.

Answer 10

JUST DO IT

Provided there are no pre-payment penalties on anything and you can agree to quickly rebuild your emergency savings back to a level you are both comfortable with, I'd encourage you to go for it. That's four bill payments a month. It sounds like that's four sources of stress to your wife every month.

Just think about never sending in another student loan payment or car payment. Think about having a wife that isn't stressed out when those bills come in. Think about being able to drop that $1000+ a month into a Roth and watching it grow instead of sending it to the car dealership or Sallie Mae.

Answer 11

While I understand your concern about "draining your account", I'd suggest looking at it from a different perspective:

If you had $7K in the bank, would you go out and borrow $48K just so that you feel prepared for emergencies? While you have debt, the money in your bank account isn't really yours any more than if you had borrowed it, so it's a bit of a false sense of security.

Also, regardless of interest rates, there is a definite psychological win to being debt free. And you're in quite a good spot with your income as well - with the debt off your back, and $5300 extra per month (plus interest savings), you'll be able to easily rebuild your emergency fund in right around 9 months!

Answer 12

I like GOATNine's and Nathan L's answers, and for different reasons. I've up voted both of them.

GOATNine's answer has you look at the closing fees/costs to make sure it's a good fit, which you should definitely do.

However, I like Nathan L's answer a lot more. Getting rid of debt is usually a great thing in general, and helps your credit score, too. Even if you don't continue to pay off the rest of your debits over 6 months, you've put a serious dent in your debt and your debt to income ratio will still have become much better for you.

To add to those answers, I'm going to suggest looking at your credit history first. To a certain extent, your credit score is dependent on how long you have loans or lines of credit. The longer the better, usually. Having loans that aren't very old can negatively affect your credit score, where having "old" loans can help.

Do some research, and maybe consider consulting a financial adviser before doing anything. Paying off any recently acquired loans first might be the way to go. Keeping a mix of old vs new loans might work better. I'm not sure if having new loans matters, if you have old debt.

Generally, keeping lines of credit is better than having loans, so I'd suggest looking into paying off any loans you have before paying off credit cards.

If you have a lot of different credit cards, now would be a good time to consider getting rid of some of them. Having a lot of different credit cards can be negative to your credit score, but you should keep a couple higher limit cards. These, as long as you respect them and use them responsibly, will help your credit score. Getting rid of the smaller cards can be slightly negative, since your credit to income ratio can change, but since you would be paying credit/debit off at the same time, it should at least even out. Or, with the amount of debit you're looking at removing, your debt to income ratio may improve so much that anything lost due to getting rid of small cards won't even be noticeable.

As an aside, you might want to look into investing into a 401k or IRA for retirement, due to how well you are saving. Those investments will pay out much better returns than a savings account. Other investments can also help you save for retirement, but this is going way off topic here.

After all this research, you may find out that keeping 1 old/long term loan until it naturally is paid off is worth the interest, if it continues to help your credit score. Maybe it doesn't, but do a little more research to see what's good for you. I know paying off all your debt sounds great (it really does), but it might have some unfortunate negative impacts as well.

Just make sure that you and your spouse agree on the final decision, or you might end up on the IPS site next, asking how you can fix the problems you accidentally created here.

Good job at your savings and keep it up!

Answer 13

A few points to consider before making the decision:

1. The pre-payment penalty - Sometimes you have to pay a penalty if you close your loans early. Talk to your bank and check how the penalty compares against savings you will make by pre-payment. If the penalty is small enough, it may make more sense to pay it off.

2. Tax-saving on interest - In my country you can claim tax deduction against interest paid for education and home loans but not on car or personal loans. Pay off the loan that can't be claimed in tax deduction.

3. Higher interest loan - Pay off the loan with higher interest rate first. Keep the other.

4. Larger installments - Instead of paying off the entire debt in one go, maybe you can increase the monthly installment. This will reduce the outstanding debt faster without wiping out your savings.

Answer 14

First look at the quality and kind of debt.

In the USA, student loans cannot be discharged in bankruptcy; but they can sometimes be forgiven if you fall on hard times. On the other hand, some retirement investments cannot be lost in bankruptcy.

Second, car loans at low rates like that are usually because the alternative was a discount for paying in cash, or some other trick. The original interest rate was probably 8%+, because securing a loan against a car is a stupid thing for a bank to do. But now, the benefit of paying it off early is only 3%. Car loans can be discharged in bankruptcy (at the cost of losing a car, which is usually worth less than the car loan anyhow).

Your expenses are currently ~4k$/month. One rule of thumb is to have 6-12 months of living expenses availiable: that is 24-48k$. You currently have more than the high end.

What I would consider doing is:

1. See if you can get a 10-20k$ unsecured line of credit at prime+3% or so.

2. Drop your savings down to 6 months -- 24k$. Use the rest to pay off loans.

Start with the student loans at 6% and go down. The ability to reduce payments due to hardship is not as useful as the ability to discharge in bankruptcy, and the car loan is smaller.

You'll end up with a 10-20k$ line of credit (empty), 9k$ in student loan debt, 8k$ in car loan. Your "leftover" cash will go up by 300-600$ (depending on amortization).

Say 5000$ leftover per month. If you put half of this towards debt clearance, you are now 8 months away from being debt free.

The 24k$ in savings plus the line of credit gives you enough money to both buy a brand new car and replace a roof before having to stretch or use credit card debt. (See above comment about why car loans are bad).

Now start saving 2.5k$ a month. Over 10 months you'll recover to your 55k$ in savings.

So 1.5 years from now you are debt-free and sitting pretty, without having to stress your lifestyle or risk a low bank account balance.

Answer 15

Your goal should be to build equity and maximize net cash inflow. Equity isn't cash in the bank, it's the difference between what you own and what you owe. When you look at cash flow, you want to minimize the tax and interest you pay relative to the income you earn.

Consider the difference between the interest you would earn on money in the bank vs interest you pay on money borrowed. Chances are, you are earning little to nothing on your savings while paying all that money in interest. It's a net outflow you don't need. Once you've paid off the debts you have additional cash flow freed up from the interest you are no longer paying. You could then use that money to either buy stuff or save for a rainy day. If you like the idea of ready cash for an emergency, do as suggested in other answers and set up a line of credit; it should cost you nothing unless you have a balance on it; over all, you will be better off financially.

The only time it makes sense to not pay off a debt when you have "money in the bank" is:

1. Interest rates have inverted (rare but not unheard of) - you earn interest at a higher rate than you are paying on money borrowed. Banks avoid this because they make their money on the spread between savings and loan rates, but economic fluctuations can occasionally (temporarily) create situations like this.

2. There is a penalty to pay off early. Here is where some careful math is needed. If the penalty is high enough, it might be better to keep the loan going until it matures; however, even with a penalty, it might still be better to pay off the debt, penalty and all, to minimize the final total cost of the loan.

3. The "money in the bank" is actually some form of registered retirement savings to which you contributed in order to get a tax refund (reduce your income tax for the year you did it). Collapsing a retirement fund prior to retirement should be a last resort because you will end up paying income tax on that money, potentially cancelling out the entire tax benefit it gave you in the first place. When the tax you've saved outweighs the interest you'll pay, it can make sense to borrow for an investment or keep a loan going.