Paying down debt is no fun, but it’ll help you in the long run
We’ve written at length about our golden ratio for budgeting, the 50/30/20 Rule. A quick explainer: this budget allocates 50% of your net income to paying for your fixed costs, like housing and food; 30% goes to your “wants,” like Netflix or concert tickets (RIP); and 20% goes to your goals, including meeting savings goals and paying down debt.
This ratio is sweet because it provides a consistent but still flexible framework to keep perspective on reaching your financial goals. Of these three categories—needs, wants, and goals—the first two are pretty self-explanatory. But how do you design financial goals that are more focussed than “I put money in account, money get bigger”?
We’ll give you our two cents, but financial goals are incredibly personal; no two people will have precisely the same goal and the same means to achieve it. Your financial goals have to come from you and your own careful consideration.
Pay Down Debt First
We’ll just be straight up here: pay down your friggin’ debt.
To be more specific, and for the people in the back: pay down your friggin’ debt before you really dig in to saving.
There are different schools of thought on this, but we feel pretty strongly that there are extremely few circumstances where saving will benefit you more in the long run than paying down your loans or credit card debts ASAP.
This is because, while possible, there are extremely few circumstances where you will earn more on your savings than you’ll have to pay back on what you’ve borrowed.
Meaning, your return on investment (or interest earned on savings) would have to outpace the compounding interest assessed on what you owe.
On most major credit cards, interest is assessed at between 19% and 30%, which is absolutely insane. Given that over many years investments in the S&P 500 (a widely used stock market index) will return about 10% on average,1 unless you’re able to save huge amounts in a very short time in a very good year, your money saved will not outpace the accumulation of interest on your debts.
At best, your savings and returns will be gauged by your debt; at worst, they’ll be totally cancelled out.
Saving is sexier (lmao, you know what we mean) than paying off debt. We get it! We all want to be grown ups, we want to save money and get in (comparatively) fun kinds of debt, like mortgages.
But in our opinion, the best thing you can do is get rid of that big dark cloud of debt.
Exceptions to the Rule
There is always at least one exception!! This is finance y’all. Read the fine print!!
Luckily this exception is more common sense than fine print: if you’ve got low interest debt on a larger scale that can be paid off over years, you can probably balance your debt payments with your savings.
Namely: StUdEnT LoAnS, and also mortgages.
The reason this circumstance is different is because what tends to get you on debts like credit card debt is that compounding interest accumulation.
But looking at student loans in Canada, your interest is assessed at 3% plus the Real Price Index (RPI), which is currently 2.6%. So on your principal balance of $30,000 today (ow), you’re paying at most 5.6%. This is very different from 19% interest, even on a smaller principal balance.
The same applies to mortgages. These are often hundreds of thousands of dollars, and with an interest rate (hopefully) below 5% (don’t… don’t take a mortgage for more than that ok?), you’ll do well to manage the interest as part of your principal balance as you pay off that bad boy over the next 10, 20, or 30 years.
The point here is that paying off your student loan debt or your mortgage can take a really long time, and with more manageable interest rates, you’re more likely to profitably pay these off with monthly minimum payments while also allowing your savings enough time to meaningfully grow over the course of years.
So if you fall into one of these categories—at least in Canada—it’s probably reasonable for you to make the agreed upon payments (set by the Government of Canada, your bank, or your mortgage broker) while diverting left over discretionary income into your savings.
You Should Spend More On Paying Down Debt
Reminder: this is different for everyone. You know your finances best and how much you can comfortably allocate to these goals.
But here’s the deal: minimum payments on credit cards aren’t enough. This is insane, right, because your minimum payment is probably already hundreds of dollars per month.
But making your minimum payment doesn’t really impact your principal balance, it only manages your interest—which keeps you in debt. If you are only making minimum payments, you will have that debt for years—even balances as low as $1,000.
This is the point. Credit card companies make more money when it takes you longer to pay off debt, so they don’t want to encourage you to make big, effective payments. We recommend you take advantage of an online credit card interest calculator to get an honest view of how aggressively you need to act (while staying within your means).
Then, set your plan and stick to it. If paying down your debt effectively uses all 20% of your allocated income (from the 50/30/20 Rule, remember?), but allows you to quash that debt in 2 years instead of 10, then so be it.
Title this financial goal “You know I had to do it to ‘em”. Pay off your debt. Once it’s gone, buy yourself a smol treat (because that was hard, and you deserve it) and then get into the fun stuff: savin’ yer money, and becomin’ a millionaire.
1 Maverick, J. B. “What Is the Average Annual Return for the S&P 500?” Investopedia, https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp. Accessed 4 Feb. 2021.
This blog is provided for informational purposes only and is not intended as personalized tax, investment, legal, business or other professional advice, nor is it meant to suggest that a particular investment or strategy is suitable for any particular investor. If you’re unsure about an investment, you may wish to obtain advice from a qualified professional. Nothing herein should be considered an offer, solicitation of an offer, or advice to buy or sell securities. It’s important to remember that past performance is no guarantee of future results.