One of the most positive side effects of the Great Recession was that it was a wake-up call to the average American household about the perils of taking on too much debt. Total outstanding credit card debt fell by over 20% between 2008 and 2011. Unfortunately, signs are pointing toward the fact that we may be forgetting the painful lessons of the Great Recession.
Since the nadir in 2011, outstanding credit card debt has risen 30%, and in late 2017 crossed the $1 trillion mark for the first time. Concurrently, outstanding auto loans have positively ballooned, rising 75% to $1.23 trillion since mid-2010.
But nothing has ballooned quite like student loan debt. In 2010, student loan debt eclipsed credit card debt for the first time. Since then, it has almost doubled to $1.5 trillion for the entire country.
If you have outstanding high-interest loans (we'll get to what constitutes "high-interest" below), you need to do everything you can to pay those loans off. So long as you have an emergency fund established and all of your basic needs are met, it should be your top financial priority. Here are three reasons why.
1. You're getting the best guaranteed ROI possible
The interest rate you pay on these loans is a key piece of information. Almost without exception, credit card debt is high-interest debt -- which I consider to be any loan with an interest rate of 7.5% or higher. Last month, the average credit card rate was 17%.
The rest of the loans (student aid, auto, etc.) can be high-interest, depending on the type of loan and your credit score. Auto-loan borrowers with a credit rating of 659 or lower -- for instance -- report having interest rates between 9.7% and 15.2%. Most federal student loans don't qualify as high-interest, but if you get a private student loan, rates are higher. On average, they sit right at the 8% mark, but can climb to 10% or more.
All of this is important because there are opportunity costs with paying down your loans: There are other -- potentially more profitable -- things you can do with that money. Namely, you could simply make minimum payments on your debt and invest the rest in the stock market.
Since 1871, the market's annualized return sits at 9.1%. Technically speaking, if your loans had a 9% interest rate, you'd make more money in the long run by only paying the minimum and investing the rest in the stock market.
But what makes sense on paper and how things play out in real life are two very different things. The stock market rarely has a "typical" year, and it can be harrowing to see your investment balance bounce all over the place -- knowing you could be paying off your debt with that money instead. That's why I bumped the definition of "high-interest" down to 7.5% -- it provides a margin of the safety for your finances.
In the end, your return on investment (ROI) for paying down high-interest debt is huge. And the higher the interest rate, the higher the return.
Here's what I mean: If you have a $10,000 credit card balance with a 17% interest rate and you pay it off right away, you've spent $10,000. If, however, you pay it off using minimums over the next 10 years, you will end up having paid over $20,000 total. Therefore, your ROI by paying it off immediately is 100% ($10,000 saved on a $10,000 payment) over 10 years -- a pretty good return. And unlike the stock market, that return is guaranteed.
2. A crisis will make you vulnerable
Whether we like to admit it or not, life is far more unpredictable than we think it will be. Injuries on the job, illnesses in the family, natural disasters, divorces, and economic crisis happen with regularity. When they hit, our finances become strained.
Sometimes, they can become so strained they break. Best-selling author and former trader Nassim Nicholas Taleb refers to these as "Uncle points" -- where you have to cry "Uncle" and presumably file for bankruptcy.
Usually, a household has some wiggle room when a crisis hits: a vacation can be put off, you can leave the organic goods on your grocers shelves, and you can wait a few months before buying those new jeans.
When it comes to paying off debt, however, collection agencies don't like making exceptions. At the very least, you will have to make minimum payments every month. And even if you file for bankruptcy because of such unforeseen occurrences, your student loan debt will follow you.
If, on the other hand, you prioritize paying off high-interest debt, you can set yourself up to actually profit when the market tanks. Stocks go on sale, the price of goods goes down, and even real-estate -- like in our latest recession -- drops dramatically. When that happens, only those who have dry powder -- cash in the bank -- can benefit. By eliminating high-interest debt and accumulating that cash, you set yourself up to be resilient in the face of such times.
3. Forcing yourself to live on less could be a life-changing exercise
Finally, there's a softer emotional aspect to paying off your debt -- it forces you to consider what your own level of "enough" really is. It's always been tempting to keep up with the Joneses, but in this age of social media, unnecessary spending on status symbols is exacerbated.
If you force yourself to stop spending and start paying down high-interest debt, you might realize something life-changing: You quickly adjust to not having those "extras" in your life, and don't really suffer in their absence. This is the upside to hedonic adaptation, which you can read more about here.
The key is that this can lead to a monumental shift in finances: realizing the true gift that money brings is freedom of time, not freedom to buy whatever you want.
The bottom line on debt
Not all debt is bad. It can help you get the things you need: a college education, a roof over your head, clothes to wear, and a car to get around in. But whenever possible, you should avoid it -- especially when it's the high-interest variety.
Because life isn't perfect, Americans have loaded up on high-interest debt. Paying it off ASAP is a huge priority: It will give you a guaranteed and substantial ROI, it will help make you more resilient in times of crisis, and it can even help you match your financial and emotional priorities.
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