I have noticed a trend involving wealth building that is all wrong. I see it in comments on other personal finance blogs a lot lately. I am sure it has been there all the while and it only jumped out at me recently for whatever reason. The misinformation is so important it needs clarification.
The comment goes something like this: I am not saving right now because I am paying off student loans/credit cards/car loans/making extra mortgage payments. When you pay down debt you ARE saving and also building your net worth. The real question is: How can you balance debt reduction with retirement savings for maximum net worth building?
Paying down debt removes the most caustic item on your balance sheet holding back wealth creation. Debt interest is an expense you can only slay by destroying the debt (paying it off). Debt is not a bad thing in and of itself when used as a tool, but most consumer debt is bad. Mortgages are the exception if used properly.
Let’s take some time to explore the best way to reduce debt and maximize return and net worth.
Pecking Order of Debt Reduction
We will address retirement savings in a moment; for now we will focus on debt only. My opinion is built on maximum return for each action you take which is different from other personal finance gurus like Dave Ramsey. Ramsey teaches you should pay the smallest debt balances first (snowball effect) so you reduce the number of bills quickly, giving you a mental boost. I was a Dave Ramsey Endorsed Local Provider (ELP) for years; I am very familiar with his teachings. My advice is slightly different.
I assume we are all adults and understand LESS debt (especially consumer debt) is better. You don’t need hand-holding or mental tricks to act like a responsible adult. You are here because you want to grow your financial understanding and increase your net worth.
The debt with the highest interest rate should be paid down first! Eliminating the highest interest debt does give a psychological boost as interest is reduced at the fastest rate. It also allows for faster net worth accumulation.
Debt payoff IS saving! Think of it this way. Example: You have several loans and a mortgage with payments of $2,000 per month of which $1,600 is interest. Making the minimum payment will increase your net worth $400. Do you get it? You made $2,000 in payments which included $1,600 of interest and $400 loan principle. The $400 reduces your balance, thereby increasing your net worth. Any extra payment will all go to paying down the debt eliminating interest on that part of the liability forever.