It’s probably my Lutheran upbringing that makes me wary of extremism in any form. Moderation in all things, doncha know.
Lately, I’m noticing extremism when it comes to paying off debt.
People think they’re doing the right thing by targeting student loans and mortgages for early payoff. But they could be hurting themselves if they’re stinting their retirement funds or leaving themselves with too little financial flexibility.
Let’s take student loans. Their interest is tax-deductible. If they’re federal loans, they have fixed rates and a number of consumer protections, including the ability to delay payments if you run into economic hard times.
Once you prepay those loans, though, the money’s gone. You can’t borrow it back, as you could with a line of credit.
I just heard of another family that rushed to pay off student debt, only to face an emergency fund on fumes when the father was furloughed.
Mortgage pre-payers face a similar problem these days. Before the financial crisis, they could have opened a new equity line even if their incomes were diminished or non-existent. These days lenders are wary of anyone who’s lost a job, which can make borrowing against a home problematic when you’re facing a financial crisis.
One solution is to open a home equity line of credit and keeping it open and unused for emergencies. Another is to simply make sure your debt payoff strategy makes sense with your larger financial picture. If you’re not saving enough for retirement or emergencies, those should be your priorities long before you target low-rate, tax-deductible debt.
Liz, I agree with moderation, and feel strongly that one needs an emergency fund PRIOR to focusing on eliminating debt. However, student loans can tie up family case flow for decades if not addressed, and it is rare to become homeless if one OWNS their home free and clear. I agree that retirement savings and compounding is important, but going into retirement with an outstanding mortgage is a huge strain on a limited budget. In our house, we are attacking the debt we accumulated through second career college degrees and plain old stupidity…and once that is gone we will have over $1K a month to invest with no debt except the balance of the mortgage, which we are throwing extra at as well.
The problem with putting debt, especially mortgage debt, ahead of retirement savings is that it becomes harder and harder to “catch up” with retirement savings–until it becomes impossible. You simply don’t have enough time to benefit from the power of compounding so you have to try to save huge portions of your income, which for most people isn’t possible. That’s why it’s important to get started saving for retirement as soon as possible and fit the other goals, including paying off debt, around that.
The nasty thing about paying off debt early is that you leave evidence of the ability to pay far in excess of the minimum payment, which leads the lender to increase your credit line. That becomes a trap when you use it.
But only if you use it. Otherwise, the larger line of credit helps your credit scores.