Updated on 09.16.14

Why Debt Reduction is My Personal Finance Target

Trent Hamm

Recently, I had an individual write to me, telling me a lengthy tale of his mortgage. He was currently paying about 6% on it, but he had an adjustable rate on it and it could go up to as much as 7% in a few years. It was clearly worrying him, even though he knew he could make more by investing it elsewhere. He wrote to me hoping, I think, that I would tell him that investing it was the right idea.

Instead, I told him to get rid of the debt.

That will probably surprise some people, especially since I regularly tout the returns of index funds that have been returning in the double digits (on average) for years. A double digit return will blow away that mortgage interest rate, putting the investor way ahead of the game in a pure numbers sense.

Strictly on paper, it does make more sense to invest extra money instead of putting it into debt repayment if the debt’s interest rate is low. To me, though, personal finance is more than just what’s on paper. The “what’s on paper” part is the finance part, not the personal part – the personal part is much, much more than that.

It comes down to your personality and your tolerance of risk. Debt is a risk – don’t let anyone tell you otherwise. You’re putting your future self at risk every time you incur debt – you’re making the assumption that your future self can repay that debt.

If you’re kept up at night by debt, it means that your current financial situation is exceeding your risk tolerance and you should be focusing on getting rid of that debt. Ekeing out a couple more percentage points in an investment is not worth being uncomfortable with your investment situation.

Some people have more risk tolerance than others. Mine is pretty low, so I’m always in favor of getting rid of that debt. Others have very high risk tolerances – people who flip real estate, for example. It’s not bad or good to have a high or low risk tolerance; it’s just different. People with low risk tolerance might not get the best return, but they’re much more prepared for situations where the future doesn’t turn out as expected. People with high risk tolerances might nail a massive return, but if the future deals them a bad hand they may be completely unprepared to handle it well.

If some aspect of your financial life is keeping you up at night or occupying your thoughts, take care of it. If you’re sitting there nervous about your mortgage and you have the money to pay it down, pay it down – don’t sweat the fact that you might make a couple percentage points more in an investment. If you’re paying extra on your mortgage and it’s bothering you that you could potentially get a better return in the stock market, investigate and invest appropriately.

For me, I’m pretty much looking straight ahead to the day that I’m debt free – I’m dipping my toes just a bit into investment, but my real goal, above all, is to be free of all debt as soon as possible. It is debt that worries me and keeps me up at night – it’s debt that makes me feel locked into certain lifestyle choices. Thus, debt reduction is my personal finance target.

What’s yours?

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  1. dong says:

    I agree wholeheartedly that it’s matter of personal preference towards risk. However, I think the issues are actually more complicated. By paying the house down instead of investing, you could expose yourself to other risks. For example the housing market might be stagnant, but inflation elsewhere goes rampant effectively generating a negative return on the money you’ve plunked down in the house. Investing in the house exposes yourself to this risk. Again, I think generally paying down debt is the “safer” thing to do, but sometimes you’re trading some risk for other types of risk. Personally if I were in the letter writer’s situation, and planned on staying my house, I’d refinance to a fix rate – effectively making my immune to interest moves and inflation, and invest elsewhere….

  2. Robert says:

    I think many times the problem is goals. Someone with goal A takes advice from someone whose goal is goal B.

    I agree with Trent in that I tend to pay off debt. But, I now have paid my house down a good bit and have eliminated all other debt. My long term goal is for my wife to quit work when we have kids (about 2 years away). To do this, I need to know that I have enough liquid cash to cope with a disaster.

    With that in mind, my goal is to get about 20 thousand dollars in the bank making 6% interest. Once I get to that point, my goals will change again. I will probably then begin focusing on the house again.

    I believe Trent said something to this effect in an earlier writing. Figure out what your goal is first, then plan accordingly.

  3. Chris says:

    I find it ironic that on the same day you post this article, you also posted “The Ten Biggest Money Mistakes I’ve Made Since My Financial Meltdown” where #10 stated that you focused too much on eliminating debt.

    I believe that one should invest the extra money until the interest on the mortgage no longer meets to minimum standard deduction. Even then, as long as one has a comfortable emergency fund, I would advocate investing.

    However, with the nature of some ARMs (explosive/interest only), perhaps the individual should instead examine a fixed mortgage and ensure relative stability in his housing budget.

    As always, personal finance is just that…personal.

  4. I think I will tend towards a medium risk situation. I don’t see my mortgage as a huge liability at this point (but I may see it different in three years when the rate adjusts, but I also may have moved by then!) Once we have enough money securely sacked away for emergencies (6 months worth), then I’ll mostly put money into investing. I may pay off a good chunk of our higher rate mortgage (we have two, one smaller one at 8%!), but it will perhaps be 25%/75%, heavier on investing.

  5. Lynnae says:

    I absolutely agree with you. I’m a “low-risk tolerance” type person, and I can’t wait until the day I’m completely debt free. I don’t want to bank on the future to pay off my debts. Too much can happen to change a person’s financial situation in a heartbeat.

  6. j2r says:

    Agree with FamilyFinanceBlog.
    It doesn’t have to be either or.

    You can put 50/50 or 25/75 or 75/25.

  7. Minimum Wage says:

    My low earnings and high debt are keeping me up at night. Can’t resolve the debt until my earnings improve but can’t afford training or education.

  8. Leo says:

    Great post. I tend to be at around the same areas as you are, Trent, along the acceptable-risk spectrum. Perhaps it’s a commonality among people like us who have been burned by debt problems in the past and know how difficult it is to eliminate it once you’re deep in debt? Excellent job as always, Trent.

  9. Fred says:

    It does not say in the post whether he is contributing to any type of retirement. I think that before looking toward principal reduction you should be maxing out 401k and IRA accounts. I would also look at a refinance to lock in a fixed rate. My loan moves to an adjustable in 2 years, so I’m looking at refinancing or selling before then.

  10. I’m not a fan of debt, even a mortgage. Remember, the origins of the word mortgage mean “death pledge.”

  11. Celeste says:

    Four years ago I refinanced my house to a 4.25% fixed 15 year mortgage. While I want to pay off the balance and be debt free, for now I am putting the extra dollars at least in a money market account that earns 4.5%. If I can earn more than the interest I pay, I feel that making the money is better than paying off the mortgage. I am also fortunate in that I am contributing the maximum I can into retirement and also have about 4 months of emergency money tucked away. Besides, I have been paying a little extra and now have only 10 years to go.

  12. kitty says:

    I think it depends on a number of factors in addition to risk tolerance: age, job security high among them.
    While stock market return has been high over the long term, there were 20 or so years periods when the return was very low or the market dropped. If you happen to need or want to retire within a year following market crash, you don’t want to be stuck with mortgage. Similarly if you loose your job right after the market crash, you’d appreciate a paid-off home.

    So I think if you are in your 20s and have a secure job, it makes sense to invest the money. If you are in your 40s or 50s or if your job is not very secure, it makes sense to compare the mortgage rate with guaranteed investments rather than stock market return. For example, I wouldn’t pay off 4.5% mortgage (provided the interest is tax deductible) if I keep an equivalent amount in 5.5% CD or high interest saving (in addition to whatever money I have in the stock market), whereas I’d pay off a 7% mortgage.

    I was burned by the way by counting too much on stock market returns. At the height of the internet boom a friend of mine suggested I sold some stock and paid off my mortgage using my gains. I said that I was earning higher percentage on the stock market. Then internet bubble burst, all of my gains evaporated, but I still had my mortgage. OK, maybe my investments weren’t sufficiently diversified, but even with diversified portfolio there are no guarantees.

    when a couple of years ago I had a windfall from the sale of my old condo I was renting out, I decided to pay off my mortgage (taken in late 90s, so it was around 7% for 30 year fixed). If my mortgage had been 4.5%, I’d just put the money on a CD. Maybe I should’ve refinanced, but the idea of not having a mortgage seemed very appealing to me. But… Had I listened to my friend and paid off my mortgage using gains from stock market, I’d be considerably richer now as my stocks are still below where they were at the height of internet boom.

    By the way, it feels really good not to have mortgage.

  13. I think that it is helpful Trent that you recognise that everybody is different. Personally I follow a similar principle to you as the long term reduction of debt is always the most lucrative in the long term.

  14. IASSOS says:

    That paid-up mortgage is (a) a retirement vehicle, because you get to live in the house rent-free when you retire (b) a (slow acting) emergency fund, because you can get a loan using the house as collateral (c) perhaps an investment, if values rise where you live, and you can sell out and move to a cheaper neighborhood (d) peace of mind.

  15. Mark Gavagan says:

    I am of the “pay off all debt” persuasion, after making sure to contribute to pre-tax retirement plans and benefit from your employer’s matching funds, if any.

    A benefit of this approach, along with a healthy emergency fund in cash and a fairly low overhead lifestyle, is that once our fairly modest mortgage is eliminated we’ll feel comfortable concentrating investments into well-researched higher-risk opportunities. We’ll still be fine if large losses ensue, and even more comfortable if we happen to earn huge profits.

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