Many financial experts advocate paying off debt as soon as possible so you can start saving. At first glance, this approach sounds good, but it’s not always the right financial move.
It is easy to pay off debt when you are young, but paying it off is usually a slow and tedious process. Credit cards, student loans, and even your mortgage loans are hard to build significant savings on.
There are several variations of the idea of ’debt as a snowball’. However, they all have one thing in common. The idea depends on whether you start with one debt, pay off that debt, and then apply the released capital to the next debt.
When you pay off the debt, your “free” capital increases, making it easier to pay off each subsequent debt. This is the “snowball effect”. In fact, it’s more “savings that snowballs” rather than debt that snowballs, because the savings grow instead of debt.
Suppose you have the following debts:
- Credit Card- $ 50 / month
- Credit Card- $ 100 / month
- Personal Loan – $ 300 / month
- Mortgage- $ 600 / month
If you pay off your first credit card, there is another $ 50 available for larger credit cards. After the credit card is paid off, you can use the $ 50 from the first credit card and the $ 100 from the second credit card for personal loans. This method is inherently correct, but it’s not the only way to get out of debt. In fact, it may not even be the most effective.
The idea behind debt arbitrage is that you can get more investment income than the cost of debt. As long as the money you free up is used for investment, you can overcome the interest rate on the new consolidated loan.
Keep in mind that after refinancing the debt, you still have to pay the normal monthly costs. For example, if you used cash refinancing to consolidate all of your debt into a new mortgage, the loan will be paid off according to the established schedule. Hence, you don’t have to worry about never paying off these credit cards.
At the same time, you put the released money into your work. If your new consolidated loan rate is 5% and you invest your savings at 6%, your income will always exceed the cost of debt.
If you’re doing math calculations and your investment is tax-deferred and can get a compound return, your return can be up to 2 percentage points lower than the loan rate. Deferred taxes and compound interest make up for the fact that the interest on your loan is higher than the investment interest.
Once your accumulated savings equals the remaining debt, you can use your savings to pay off the debt in full. Since your normal monthly payment will continue to reduce the monthly payment’s total outstanding debt, and you are building money at the same time, you can pay off your total debt faster than with “debt snowball.”
You can even choose to extend the term of the debt and keep saving your savings. As long as your investment income exceeds the interest paid, you will always be in a leading position.
The only way to know if this arbitrage strategy is working for you is to contact a financial planner and prepare a financial plan. Calculate some numbers and see which method of paying off debt is best for you.