So you’ve been paying off debt for a little while now, when is it time to stop paying debt and start saving?
You shouldn’t completely stop paying debt until it is completely paid off – clearly you need to keep paying minimum payments. However, you can ease up after paying off high interest debt (I define this as anything with an interest rate above 5%). When you reach this point you can start rolling money into savings and start rolling towards financial freedom!
Just a couple notes before digging in:
If you’ve got large debts like a mortgage or student loans on which you’re paying higher than 5%, you may want to look at refinancing. This will be very situation dependent, so you’ll need to look at how much lower of a rate you can get and how much the fees for refinancing are.
Second, if you haven’t managed to create an emergency fund to cover at least 4 months of expenses, you should focus on that and read the rest of this post later. For your emergency fund savings, I’d recommend using a high yield savings account.
With that, let’s dig in!
Why would I give the number 5%? Because in the long term, stocks tend to give a return of more than 6%. Theoretically, this means you will probably end up with more money by investing in the stock market rather than paying off debt with interest rates less than 6%.
On the other hand, there are strong advantages of paying off debt. Returns on the stock market are not in any way guaranteed, but long term savings are guaranteed on paying off debt. You will pay less money on interest, the sooner you pay a debt off.
In my opinion, that guaranteed return by paying off debt is worth getting a little less return percentage than the stock market. However, the lower the interest rate on the loans, the more likely I would be to use my money for investments.
To be clear – I’m not telling you to quit focusing on paying debts once you’re down to below 5% interest debts, and for you to just go do whatever with your money. Whatever you do, if you stop paying as much on debt, make sure that money gets directed to investments! Paying off your debts is a time to celebrate, but it is not time to lose focus on financial freedom!
As mentioned earlier, if you redirect money from paying debts to investments, you should focus on higher returns and for the longer term. One great example of where you may want higher returns for the longer term is saving for retirement – this is not necessary the case if you’re very close to retirement though. If you’re close to retirement, it would likely be good for you to focus on paying off debts.
Here’s a couple quick reasons of why you’d want to focus on debts if you’re nearing retirement.
Debts will almost always have a minimum payment, so they’ll always take a chunk of your budget. If something happens with the market and it drops, you will likely want to flex how much money you spend. Unfortunately you can’t flex your budget as much when you have fixed payments in it.
If you’re nearing retirement, you will likely want to limit the risk of your investments. This means you’ll probably also have a lower return. When the gap between investment returns and debt interest gets close or if investment returns are lower than debt interest, you want to pay off debt.
If you’re able to start saving and investing, you’ve made it to a good point, but you’ll need to continue on this track to reach financial independence!