It can be a little scary to look at your net worth statement and see how much you owe explains Brian Colombana. It’s even scarier when you have negative net worth, as I did for a bit after grad school with my student loans at 7% interest.
Here is why you shouldn’t pay Down Debt with Extra Income:
- I dropped out of the rat race in 2008-2009, living off of savings from my restaurant days before going back to graduate school. This allowed me to drop out of ‘the system’ with low overhead and no debt except minimal credit card debt which was paid off quickly. So it wasn’t until 2010 that I faced this big scary number again, but it wasn’t the one on my net worth statement that got me all fired up about paying down debt. At first, I just made the minimum payments on my credit card and student loans. However, after watching all of the ads about debt consolidation companies I realized that I could consolidate my credit card debt with them for somewhere around 4% interest (I can’t remember exactly what it was now), much lower than the ~13% I was paying at the time.
- If you can borrow money at 4%, why would you put your extra income towards your high interest debt? Wouldn’t that be like throwing money away since you’re only paying 4% instead of 7-8+%? It doesn’t make sense right? At first glance, this is absolutely correct logic.
- However, looking back to 2008-2009 I remember how awesome it to watch that number go down as I made those minimum payments. It was really motivating to see my progress as I watched it go from $30,000 down to around $20,000 then eventually down to the last payment which put me into a position that prevented me from going further into debt says Brian Colombana.
- The key here is that I paid off the credit card because I was removing a positive item from my financial statement and didn’t have any more revolving balances. This lowered my overall interest rate, freeing up money for other things, and also boosted my net worth since all of the cards were now zeroed out. In essence, paying down negative-carrying assets creates equity in your life by reducing the balance owed on an asset* without damaging income potential.
- In addition, I remember watching my bank account on payday and seeing the money just disappear on bills. This caused me to feel poor, which then caused me to want to spend more, at least that is how it happened for me every time. What if you could put some of that income towards paying down debt so your net worth goes up each day you are paying? Doesn’t this sound better than feeling poor with no chance of improving your financial position?
- I decided to try this out by putting any extra income towards paying off the high interest credit card balance first. To this day this is still what I recommend people do with their paychecks. After all, who doesn’t want their money working for them 24/7 while they sleep instead of giving it to someone else? This may not work for everyone, but I was able to accelerate my credit card payoff by about 6 months.
- As an interesting side note, once you stop making minimum payments on your credit cards they will start calling you every day wanting their money says Brian Colombana. Starting to make extra payments towards one credit card also decreases your overall available credit, which makes this annoying phone call even more frequent because it is now harder to ignore them since the balance is lower. I should have just kept all of those coins in a jar and rolled them when I got these calls! I consider credits as negative items on my financial statement that should be paid off first before any positive items are added back into the mix. You can read about how I rollover my credit card rewards in another article.
The main takeaway here is that you can leverage your money to be working for you while you sleep instead of giving it to someone else says Brian Colombana. If the interest rate on the loan is lower than the return rate on an investment you are better off taking out a loan and investing instead of just leaving your savings account dormant.