Have a low-interest debt? Hurry up, and pay it off!
People can understand the urgency in paying off debt with a 15 percent interest rate. But what's the rush in paying off debt with a 3 percent interest rate?
Quite often, when I write answers to reader mailbag questions, I encourage people to keep pushing hard against their debts no matter the interest rate. Almost everyone agrees that it makes sense to rapidly pay off the 15% debts, but I’ll often get a lot of disagreement about the 3% debts. People will often ask why they should hurry to pay off a 3% debt. After all, they can get a better return in other investments.
The reason is simple. It’s all about the cash flow.
Let’s start off with the basics and explain what cash flow is. Cash flow refers to the amount of income you take in minus the required bills you have to pay. Ideally, you have money left over at the end of this process, and the more cash you have left over, the better. That cash can be saved for the future, invested, or applied to extra debt payments.
Let’s say, for example, that you’re bringing home $3,500 a month. You have a $1,000 mortgage at 6.75%, a $500 student loan payment at 3%, and another $1,000 in required bills (electricity, food, fuel, etc.). At this point, you must have $2,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $1,000 to do with what you please.
Now, let’s look at your situation if the mortgage is paid off. You still has a $500 student loan payment and another $1,000 in required bills. You must have $1,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $2,000 to do with what you please.
Because your mortgage is paid off, your monthly cash flow is far better than before. This helps you in countless ways.
Let’s say you lose your job and can only find one that gives you a 40% pay cut. At this point, you’re bringing home only $2,300 a month. In the first scenario, you have $2,500 in required bills. You’re going to have to make some major scary cuts in your life in order to make ends meet. In the second scenario, you have only $1,500 in required bills. You’ll be just fine and still have a surplus.
There are countless other examples of life changes, planned or otherwise, that can significantly alter your income. The greater the amount of required bills each month, the more difficult it is to swallow those life changes.
This is why it’s nearly always useful to improve your cash flow. Improving your cash flow improves your life options. It makes job transitions far less painful, for one. When you’re fired or “downsized,” you can take a lower paying job without pain. On the other hand, you also have a lot more flexibility with your career choices as you’re able to take a lower-paying but more career-building job. In fact, this is exactly what I did: I paid off a lot of debts, which reduced my monthly required payments and made it easier for me to live on less income, which enabled me to switch to writing The Simple Dollar full time because my cash flow was in much better shape.
The worse your cash flow situation is, the more you’re tied to your current job. It gives your boss more power and you less power because the threat of losing your job is devastating. Your job becomes more stressful by default because the always-present threat of losing that job – and the pain it would cause – is always hanging over your head. Your career options are limited, too, because you can’t deal with a reduction in pay.
In short, pinching your cash flow pinches your options.
Debt pinches your cash flow, of course. For example, getting a car loan pinches your cash flow because you’re now responsible for those payments. On the other hand, living without a car loan for a while and saving up for your next car is a much better cash flow option, as it allows you to simply pay cash for the next car, keeping your cash flow as wide as possible.
Overspending pinches your cash flow, too. If you needlessly spend a lot of money, you’ve pinched your cash flow for that month. You take money away from your savings. Thus, at a later point when you need that cash for a purchase, you’re forced to rely on debt, which forcibly pinches your cash flow.
It’s because of these things that I usually encourage people to just get rid of all of their debt. Eliminating all of your debt opens that cash flow up, making it easy to save for the future, change to a different job, or make other significant life changes that would be nearly impossible with a constant debt payment hanging around your neck.
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