MasterPo says: This blog is about topics and issues that are of importance to me. I am not one of the countless blogging lemmings that are tripping over each other scurrying down the hill and off the cliff of blogging oblivion trying to write the greatest blog on the latest topic de'jour. Your comments are welcome.

September 1, 2008

Paying Your Debts is NOT an Investment!

There is a common misunderstanding that has been propagated around the personal finance world for years: Paying off a high interest debt is like getting a great return on your money.

This is not true!

I'm all for paying off debts, high or low interest, as quickly as you can is always a good idea. Obviously go for the highest interest debt first. If you can service both that's even better. The more you can pay quickly the less interest you will have to pay which is what saves you hundreds or even thousands (or more!) over the life time of the debt.

If you're lucky enough to have a 0% interest installment payment that's a different animal. Since you're not paying any interest there's no rush to pay it off quick so you may as well pay according to whatever schedule you were given. For example, last year I bought a new furnace and water heater for my house. I was ready to pay it all on the spot but the company offered me 0% financing if I paid just half. Works good for me as I can now stretch out the payments and thereby pay out of current income rather than having to take cash out of the bank. At 0% there's no extra cost for payments (I can also pay it off at anytime too if I wanted).

But the myth still exists that paying off debt is the same as getting a return. For example, the myth goes: if you have a credit card at 18% then paying an extra $1.00 to that card I like getting an 18% return on your money.


In a true return you have both the dollar and whatever amount you made (the return). To use a risk-free example: If you put $1.00 into the bank at the end of the day you will have the interest on that dollar (the return) plus the $1.00. Tomorrow you can withdraw that dollar plus the interest. Even in a stock it's similar. If you put a $1.00 into a stock or mutual fund at the end of the day you have the shares of stock/mutual fund plus the return. Tomorrow you can sell that stock or mutual fund and get back your dollar plus the return (yes, even if the stock went down you would still get something back, presuming it doesn't go all the way to zero).

By comparison, when you send that $1.00 to your debt (like a credit card) – it's gone! You can't get that $1.00 back without incurring even more debt!

While you may have reduced the future interest you are paying by making that extra $1.00 payment there is no "return" on that dollar. Saving future costs is not the same as return. It is a reduction in anticipated future spending but not a return. An economist would also tell you that inflation further erodes the value of future anticipated savings thus making the value of the extra $1.00 even less (though I do not use that as a reason not pay down your debt as soon as possible!).

So go ahead and repay your debts, highest interest first. That is a smart move. But don't fall for the line that you are putting money somewhere you will be getting a return. Savings and investing are not the same thing.

MasterPo says: If you enjoyed this article make sure to subscribe in a reader (one of the last good free things in life!)

No comments: