RPF0496-The_Risk_of_Paying_Off_Debt_Too_Fast
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00:00:15.000 | Welcome to Radical Personal Finance,
00:00:17.000 | a show dedicated to providing you with the knowledge, skills, insight,
00:00:20.000 | and encouragement you need to live a rich and meaningful life now
00:00:24.000 | while building a plan for financial freedom in 10 years or less.
00:00:27.000 | Question of the day comes in from Matt who writes in and says,
00:00:30.000 | "Thank you, Joshua, for the fantastic resource that your show has been over the past six months.
00:00:35.000 | I have a specific question for you.
00:00:37.000 | In a recent show, you suggested that a couple looking to expeditiously pay off their mortgage
00:00:41.000 | do so by piling up funds in a side account rather than in chunks at a time.
00:00:46.000 | My question, does the same strategy hold true for paying off student debt?
00:00:50.000 | My initial inclination is no.
00:00:52.000 | They're two entirely different loans.
00:00:54.000 | I believe your rationale for sitting on highly liquid cash while preparing to pay off a mortgage
00:00:58.000 | in one windfall is that a mortgage is collateralized by a tangible asset
00:01:02.000 | and that asset is exposed to market risk and fluctuations.
00:01:06.000 | Student debt is different in that it's essentially uncollateralized
00:01:10.000 | apart from my ability to earn a certain income.
00:01:14.000 | Because of that, I'd assume I want to pay it off sooner rather than later due to accruing interest.
00:01:18.000 | Am I correct in this belief?
00:01:20.000 | For context, in a few months I'll approach exactly one year since graduating from undergraduate school.
00:01:25.000 | Since graduating and beginning my first job, I've become fascinated with personal finance.
00:01:30.000 | I graduated with about $32,000 in student debt, a story all too familiar to--
00:01:35.000 | similar to some of your interviewees.
00:01:37.000 | That balance now stands at about $26,000,
00:01:40.000 | and I've taken great interest in finding every way to aggressively rid myself of the debt
00:01:44.000 | while balancing that with some of my other financial goals.
00:01:48.000 | I've spent the past nine months working in New York City for a real estate investment trust
00:01:53.000 | and have also begun my own dog-sitting business on the side.
00:01:56.000 | After my semiannual bonuses, I make about $66,000 per year
00:02:00.000 | and bring in an extra $500 a month from dog-sitting.
00:02:03.000 | I've chosen to funnel 30 percent of my dog-sitting income to extra student loan payments,
00:02:07.000 | 20 percent to a savings fund I intend to one day use to invest in my own rental properties,
00:02:12.000 | 10 percent to a travel fund, et cetera.
00:02:15.000 | I have yet to begin investing as I still feel I need to build up my cash reserves,
00:02:18.000 | and the high cost of living in New York City has proved this to be a challenge.
00:02:22.000 | Is there anything you feel I should do differently?
00:02:26.000 | So, Matt, an answer to your question-- short answer to your question is no.
00:02:29.000 | There's nothing I feel you should be doing differently.
00:02:31.000 | But let me explain the rationale behind that advice that I've given here on radical personal finance.
00:02:37.000 | The principle holds the same whether we're talking about a house, a student loan, a credit card, an unpaid medical bill.
00:02:47.000 | It really holds the same for just about any of those.
00:02:50.000 | And it's not related necessarily to the collateralization of the debt.
00:02:54.000 | Let me explain.
00:02:56.000 | The basic risk that I understand now that I didn't understand a decade ago was this.
00:03:05.000 | If you spend every last dollar that you have in your checking account on a partial debt repayment of some kind,
00:03:15.000 | then you put your back against the wall if something comes along that causes a hiccup in your plan.
00:03:22.000 | Now, if you can stroke a check and wipe out your bank account but clear a debt 100 percent by paying it fully off,
00:03:30.000 | then your back is not against the wall if you have a hiccup in your plan.
00:03:34.000 | Now, either case, you don't have the money anymore.
00:03:38.000 | You've used it to pay off a debt.
00:03:40.000 | But at least you've lowered your required expenses.
00:03:43.000 | So simple example, if you owe $20,000 on your student loans and you have a monthly payment on those loans of $200 that's required of you,
00:03:50.000 | and then you empty your checking account, send them $10,000, all the money you have,
00:03:54.000 | well, the next month that student loan bill comes due, $200.
00:03:59.000 | So you still have the same risk of the debt.
00:04:04.000 | There's another payment that's due.
00:04:06.000 | And if you don't pay, you wind up going late on your debt.
00:04:09.000 | So the risk exists because of the demanded payments, not because of the size of the debt.
00:04:17.000 | If you sent them $10,000, yes, your debt balances down by $10,000.
00:04:24.000 | But there's not been any net effect there on your balance sheet.
00:04:29.000 | But your expense statement still is going to have next month a $200 payment due.
00:04:34.000 | But now you have an empty checking account and you still owe a $200 payment.
00:04:40.000 | From a risk perspective, measuring risk in terms of your ability to make your payments,
00:04:47.000 | you have a zero-month risk margin if you write that $10,000 check.
00:04:53.000 | But if you keep that $10,000 check--sorry, that $10,000 in your bank account,
00:04:57.000 | you have a 50-month margin of error.
00:05:03.000 | That $10,000 could cover that $200 payment for 50 months.
00:05:08.000 | And that, my friend, is the risk.
00:05:11.000 | The risk applies on any debt payment where you're going to have a steady stream of payments due.
00:05:20.000 | And the risk is how many months of payments do I have in my account?
00:05:26.000 | Frankly, this is in many ways a better way to look at wealth than the way we usually do.
00:05:31.000 | We usually look at wealth in terms of balance sheet wealth.
00:05:36.000 | This is one form. Let's call this – this is kind of the American form of wealth.
00:05:40.000 | And on a balance sheet wealth, you can look down and say I have $100,000 net worth or a million-dollar net worth or a $10 million net worth.
00:05:48.000 | OK. That's fine. That's useful.
00:05:51.000 | But that doesn't translate very well to your actual life in any way.
00:05:58.000 | It's just a number on a paper.
00:05:59.000 | So let's call that the American model.
00:06:01.000 | Now there's another model way of looking at wealth.
00:06:03.000 | I've heard some people talk about this as kind of the English model.
00:06:07.000 | And it refers back to the English landed gentry wherein they had an income of so much.
00:06:12.000 | Think of Jane Austen in the Pages of Pride and Prejudice.
00:06:16.000 | The exact numbers escape me.
00:06:18.000 | But where Jane Austen talks about Mr. Darcy has an income of 19,000 per year.
00:06:23.000 | That was when your wealth is measured not by how much you own but by what your income is.
00:06:29.000 | How much income is your estate producing for you?
00:06:32.000 | That's a far more useful way to measure wealth.
00:06:36.000 | If you look at your wealth and your portfolio and you say, "I'm worth $10,000 per month," that's very useful because you can translate that into expenses.
00:06:44.000 | Now a third way, however, would be to look at it the way that I think Buckminster Fuller is the one who's often referred to as commonly talking about this in terms of months of wealth.
00:06:54.000 | So let's say that you have $100,000.
00:06:57.000 | Let's go with a million.
00:07:00.000 | Let's say you have a million dollars of wealth on your balance sheet but you spend $10,000 per month.
00:07:07.000 | Well, in this context, now you have 100 months of wealth.
00:07:12.000 | You can afford to go without working for 100 months.
00:07:18.000 | If your expenditures were $5,000 per month, then you could go without working for 200 months.
00:07:24.000 | So that's kind of a third way of thinking about wealth.
00:07:28.000 | In my opinion, each of these has their place.
00:07:30.000 | It's valuable to look at the American model, the English model, and the Buckminster Fuller model.
00:07:37.000 | I need to come up with a name for that.
00:07:38.000 | You guys tell me what name I should use for these.
00:07:41.000 | I just kind of talk about it.
00:07:43.000 | But that's essentially what I'm talking about here is if you have $10,000 in your checking account and you owe $200 per month, you have 50 months of margin, 50 months of security here where you can pay that.
00:07:56.000 | Now, practically speaking, does this mean that you should always chunk, wait and chunk up all the money in order to make a full payment?
00:08:07.000 | Does that mean that you should always do that?
00:08:09.000 | The answer is no.
00:08:10.000 | Many times you should make partial payments.
00:08:13.000 | But you should make partial payments carefully, and it will depend on the debt.
00:08:20.000 | It will depend on the interest rates, and it will depend largely on your personal situation.
00:08:25.000 | Let's start with what's probably the most important thing, your personal motivation to clear a debt.
00:08:32.000 | Matt, in the email that you wrote to me, you said that you have been working extra and then you're funneling that extra towards your student loan payments, and you're also doing with that out of your basic income, income stream number one as well.
00:08:45.000 | Now, one of the reasons why you're doing this and why you're motivated to work extra is because you have a goal.
00:08:51.000 | You have a goal of paying off this debt, and that is powerful.
00:08:54.000 | I think that emotional energy should be harnessed.
00:08:58.000 | I've been there, done that.
00:09:00.000 | There were times when I would make a payment every single day on a credit card debt so that I just could make that constant progress.
00:09:09.000 | It's really fun to put a chart on the refrigerator and see those numbers go down every month.
00:09:15.000 | That is powerful.
00:09:17.000 | And there's something powerful about the clear-cut goal of being 100 percent debt-free.
00:09:22.000 | In many ways, it's far more powerful than the positive goal.
00:09:25.000 | If you have $100,000 of debt, give me two people, one person that has $100,000 of debt and they have a goal of being completely debt-free, and the second person that has zero dollars and zero debt but they have a goal of building $100,000 in savings.
00:09:38.000 | I bet you the person with a goal of being debt-free will get there faster.
00:09:42.000 | Now, maybe not, but I think they would.
00:09:44.000 | At least for me, I would get to the zero-dollar goal because of just the clarity of that goal.
00:09:51.000 | There's something meaningful about no debt, no payments, being free of the debt.
00:09:56.000 | I'm debt-free. I can do whatever I want.
00:09:58.000 | I've cleared everything.
00:09:59.000 | I'm not a slave anymore.
00:10:01.000 | That's emotionally powerful in a way that I have $100,000 in my savings account.
00:10:06.000 | It just doesn't cut it.
00:10:08.000 | And that emotion is important.
00:10:09.000 | That emotion is valuable, and I encourage you, study that emotion and harness it.
00:10:14.000 | I've done this in the past when I was paying off debts in the past.
00:10:18.000 | One of the things that I did was I would – whenever I forewent a specific expense, maybe I went out to dinner and I would have enjoyed having a glass of wine, but it was $9 and it wasn't necessarily necessary.
00:10:36.000 | I just pull out my phone and transfer $9 from my checking account over to my debt payoff account.
00:10:42.000 | Or if you could do it right on your phone, click the thing, click "Pay."
00:10:47.000 | Because I would have spent the $9, but I'm making a conscious choice.
00:10:50.000 | That's emotionally powerful, or at least I always found that to be emotionally powerful.
00:10:54.000 | Send that $9 over.
00:10:57.000 | And so that's where the chunking, the regular chunking makes a big difference.
00:11:01.000 | You should harness that emotion.
00:11:04.000 | But you have to be sensible about where you are and the certain risks that you face because things can change.
00:11:17.000 | You may harness that emotion, but if the $9 that you sent over to the debt is your last $9 and you go into work tomorrow, guess what?
00:11:28.000 | You need food next week and you don't have any savings.
00:11:31.000 | You got to have savings.
00:11:34.000 | And so as an example, this would be where Dave Ramsey, the king of paying off debt, this is why he always encourages people to save what he refers to as a beginner emergency fund or a baby emergency fund, $1,000 in the bank.
00:11:48.000 | And from his telling of the story, when he was a new financial advisor, he probably encouraged people to focus on paying off as much debt as possible.
00:11:57.000 | And then he realized that if they didn't have a $1,000 emergency fund, that they couldn't stick it through the hard times.
00:12:04.000 | Now, they came up with the number $1,000.
00:12:06.000 | I don't know if that number is right or wrong.
00:12:08.000 | Of course, Dave, to his credit, just holds that number and holds the line very clearly.
00:12:14.000 | But I'm certain that a lot of people who are using Dave's plan use a $10,000 number instead.
00:12:21.000 | A lot of modest income earners will use the $1,000 number.
00:12:25.000 | But there are a lot of people for whom $1,000 is just not going to cut it as an emergency fund, even a baby emergency fund.
00:12:33.000 | Their lives are lived on a larger scale.
00:12:36.000 | And that's what applies here.
00:12:38.000 | Now, I don't know the right number.
00:12:40.000 | I don't know the right risk number.
00:12:42.000 | I don't know if it's $1,000 or $5,000 or $10,000.
00:12:45.000 | And I don't know how to tell you where to get there.
00:12:49.000 | I do think if I were living in New York City and earning $66,000 per year, I would probably want to have at least – especially here, the life cycle.
00:12:58.000 | So I would probably want to have at least $5,000, maybe $5,000 to $10,000 in liquid savings and not put all that towards the debt as my emergency fund.
00:13:10.000 | And let's talk the next factor.
00:13:12.000 | One of the things that's a big deal is stability of job.
00:13:16.000 | For me, if I am an entrepreneur and my income is highly fluctuating, I have a much greater risk of that income going away than does somebody who is a steady income earner with a steady job.
00:13:33.000 | So if my income is prone to fluctuation or is less stable, then I'm definitely going to make sure I keep that emergency fund there.
00:13:42.000 | I'm going to keep that money.
00:13:44.000 | If I owe $20,000 in student loans, I'm going to just keep it in a side account, make minimum payments until it starts to become a big number and I maybe can write a check for the whole thing.
00:13:52.000 | But if I'm in a dual-income household, very, very stable paycheck, stable budget, yes, we got to have that emergency fund set aside.
00:14:00.000 | But then take all the extra and clean it out and send it to the debt.
00:14:04.000 | Stability is a big thing.
00:14:06.000 | Life cycle is a big thing.
00:14:08.000 | When you're young, as an example, I think you should pay more attention to having savings because many of your costs will be chunked and will come in a way that it doesn't happen when you're older and perhaps more stable.
00:14:22.000 | First, when you're younger, it's more likely that your income is going to be changing around.
00:14:26.000 | You're going to be changing jobs as you figure out where to set your feet in terms of your career.
00:14:31.000 | You may be moving more frequently.
00:14:33.000 | Younger people have a tendency to move more frequently.
00:14:35.000 | Every time you move, what do you need?
00:14:38.000 | Money.
00:14:40.000 | To get a good deal, to get a good apartment, get a good price, whatever, you need significant amounts of money.
00:14:44.000 | First, last, and security.
00:14:46.000 | The more money you can put up to make your landlord happy with you, the better of a deal you might be able to get.
00:14:52.000 | So if I were 26 years old and I were – or in my early 20s, I would be looking to say, "How can I use my money to help me lower expenses?"
00:15:03.000 | Can you prepay just little things that young people should always be looking for?
00:15:07.000 | Can you prepay rent?
00:15:09.000 | A lot of times if you can prepay rent, you may be able to have a better deal with a landlord.
00:15:13.000 | That can be much more helpful than some other investment opportunity, just lowering expenses.
00:15:18.000 | Now flip that around.
00:15:19.000 | Somebody is 45 years old.
00:15:21.000 | They've lived in the town they live in.
00:15:23.000 | The children are at that age, that middle age in which it's harder for them to handle transfer of location.
00:15:30.000 | Well, now it's less likely that their life is going to be messed up all of a sudden.
00:15:34.000 | They're going to go and get an idea to start a new job or start a new business or move and come up with first, last, and security, et cetera.
00:15:41.000 | So these are some factors that make a big difference in terms of the risk factors.
00:15:45.000 | You got to look at yourself and say, "Is there something coming down the road that is – that could upset this plan in which I might need more money saved?"
00:15:55.000 | If you got fired from your job, you'd much rather have $10,000 in your savings account than owe $10,000 less on your student loan which still keeps a positive balance.
00:16:11.000 | Then the last factor is this, which is very important.
00:16:15.000 | I shouldn't have saved it for last.
00:16:16.000 | Interest rates.
00:16:17.000 | Interest rates matter big time.
00:16:19.000 | Interest rates and the amount of time to pay off a debt will make a huge difference in this decision.
00:16:26.000 | If you owe $20,000 on your student loans and they're at a fixed 5% rate, fixed 6% rate, something like that, that's a very different scenario than somebody who owes $20,000 on their credit cards and they're at a fixed 23.9% rate.
00:16:47.000 | On the 23.9%, it very much helps you to have every dollar you can sent into that credit card as early as possible.
00:17:03.000 | It is so hard to get out from under the wheels when you're paying 24% interest.
00:17:10.000 | But at 5%, there's not nearly as much of a differential.
00:17:17.000 | And so the way you figure this out is simple.
00:17:20.000 | Calculate how long it will take you to get out of debt.
00:17:25.000 | Let's say it's two years.
00:17:27.000 | One year.
00:17:28.000 | Let's go with one year.
00:17:29.000 | Young guy, you can get this debt gone in a year.
00:17:32.000 | One year, you look at it and say, "Okay, I'm going to get out of debt in one year."
00:17:35.000 | How much would you pay in interest on your student loans under the current interest rate?
00:17:43.000 | If you owe $20,000 at 5% and the balance weren't decreasing, there'd be $1,000 of interest.
00:17:51.000 | Then the second calculation that you make is how much interest would it be if I put as much money as possible to this every single month?
00:18:01.000 | You can figure this out.
00:18:02.000 | You make a simple spreadsheet and use the debt payoff spreadsheet and put this in there and it will tell you, "Okay, if I pay – if I owe $20,000 and I'm paying – $20,000 divided by 12 is $1,666 a month at 5%.
00:18:20.000 | We run that amortization schedule.
00:18:22.000 | Let's say you wind up with $450 of – $500 of interest that you're actually going to pay because the balance is going down so much more quickly."
00:18:30.000 | So the decision comes down in a very simple way.
00:18:33.000 | Is it worth it to me to pay $500 more in interest and to be able to have my $20,000 available to me throughout the year?
00:18:45.000 | Or is it worth it to me to pay less interest and not have access to the money?
00:18:54.000 | The answer to that question will determine what you should do.
00:18:58.000 | I don't know how to answer it for you.
00:19:01.000 | When I was younger, early 20s, paying off debt in that life cycle, I would have chosen and did choose to pay it off as quickly as possible and save the money.
00:19:14.000 | And I got huge value from the emotional energy.
00:19:19.000 | Huge value.
00:19:22.000 | But when I got laid off from my job, I didn't have as much money in the bank as I would have liked to have had.
00:19:29.000 | And I didn't have as much flexibility as I probably would have liked to have had.
00:19:34.000 | Was it the wrong decision?
00:19:36.000 | I don't know how you apply right and wrong in this situation.
00:19:39.000 | But I was pretty happy with it.
00:19:41.000 | I'm still pretty happy with it, just acknowledging that maybe it wasn't perfect.
00:19:45.000 | Today, however, where I have many more people depending upon me and it's much more important to maintain a stable life and a stable lifestyle, today I would make a different decision.
00:19:57.000 | When I was single in my early 20s, I was in a place where I could easily – I could be very nimble.
00:20:03.000 | I was very nimble.
00:20:04.000 | I'm a whole lot less nimble today.
00:20:07.000 | That's not right or wrong.
00:20:08.000 | I don't regret it one bit.
00:20:09.000 | I'll take today over then any day.
00:20:11.000 | It's way better to be 32 years old, married, beautiful children, dogs, all the stuff that comes along with it.
00:20:20.000 | It's way better than being 21, 22, 23 years old, newly out of school, single.
00:20:27.000 | Trust me.
00:20:29.000 | It is way better.
00:20:30.000 | But it's different.
00:20:32.000 | And for the stability of my family today, I would chunk that up and stroke the check in big chunks.
00:20:38.000 | Judge for yourself.
00:20:40.000 | Hope that was helpful.
00:20:42.000 | This show is part of the Radical Life Media network of podcasts and resources.
00:20:48.000 | Find out more at RadicalLifeMedia.com.
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