Part I: Should You Always Pay Off Consumer Debt?

It would seem that the question posed, “Should you always pay off consumer debt?” has an obvious answer: yes. Before you just automatically jump to that conclusion, however, let me add some twists to your thinking. To me, the most interesting thing about the question is that debt elimination isn’t just an economic decision. If you think about it, debt elimination is also a psychological and spiritual decision.

To follow mainstream thinking, however, we’ll start with the economic end first. Are there times when it might not make economic sense to pay off a loan? Surprisingly, yes. Let’s say, for example, that you have recently consolidated your consumer debt into a low interest second mortgage1. As you know, the money paid on second mortgages is generally tax-deductible (which means your real cost of borrowing is actually lower than your stated interest rate).

Before we jump to paying off that second mortgage, we need to ask another question. “Are your other investment options earning a rate of return higher than your second mortgage rate?” If so, you would be better off putting current dollars into those choices rather than paying off your second mortgage.

From a psychological and spiritual standpoint, however, the inner peace you might obtain by paying off the second mortgage may far outweigh the advantage of getting a higher return by investing elsewhere. There are two roads here – one road leads more directly to wealth (putting the money in the highest returning investment) and one road is a less direct route to wealth, but more scenic and peaceful (the psychological freedom of having the second mortgage paid off).

It’s your choice. The danger of debt from an economic standpoint is that you have compounding working against you rather than for you. Nevertheless, taking the route that offers more peace of mind and lower stress can also be a good choice.

If you decide to go with “lower stress,” here’s a bonus: The closer you get to being debt-free, the less those out of the blue unexpected oddball expenses will concern you. In fact, once you are completely debt-free, you will be able to begin planning and saving for every possible eventuality. The freedom in being able to say there is no such thing as an unexpected expense can be wonderful!

Part II: Should You Pay Off Your First Mortgage?

Since we’ve mentioned a second mortgage, let’s also spend a few minutes talking about the pros and cons of paying off the first mortgage. Should you do it?

Let’s start with the arguments from those who say “no.” One reason not to work on paying it off would be the fact that it is typically a lower interest rate loan than any of your other consumer borrowing. In addition, it is also tax deductible.

This line of thinking would suggest that if you have other outstanding debts such as credit cards or installment loans at higher interest rates (and non-deductible), any excess dollars should be applied to those debts first.

The folks who advise against paying off your mortgage generally also advise that you first set aside your funds for emergencies2 and for investments3. However, if you do happen to still have money left after all that, then ok, go ahead and pay down the mortgage if you really have to.

My response to this advice: It may indeed make sense to hold off on prepaying a mortgage when:

1) you have better investment alternatives;
2) you are not saving sufficiently for retirement;
3) you are nearing the end of the loan; or
4) you have substantial credit card debt.

Now let’s look at the opposing point of view. Those who say that you should prepay your mortgage argue that you can significantly reduce the length of your mortgage, and in the process save buckets full of dollars in interest charges. (Buckets full of money that can later be used for other purposes.)

Here’s an example of what you could save by paying early: If you have a $100,000 mortgage at 8% for 30 years, paying just one extra dollar per day would save you over $27,000 in interest and shorten the length of your loan by more than four years! You don’t have to make huge extra payments to save substantial money.

In addition, those who counsel you to make prepayments also argue that you will have that psychological benefit we mentioned before – the inner peace of knowing that you have no debts.
If this appeals to you, your first action should be to decide on the additional monthly amount that you can pay.

One interesting approach is to make the next month’s principal payment along with your normal monthly payment each month. Your lender can supply you with the amounts of your principal payments if you don’t already have them.

Each time you make the next month’s principal payment, you will have saved yourself a full month’s actual payment and shortened the overall length of your loan by one month. That could bring you some major peace of mind.

Obviously this approach is easiest early on in the mortgage when the additional principal is smallest (since the early payments are primarily interest). As months go by, the amount going toward principal will gradually increase. If you eventually find yourself in a position where you can no longer handle adding the entire next principal payment, just pay whatever additional money you can. You’ll still save substantially in interest charges and have the mortgage paid off sooner than you would have.

One quick warning: If you are interested in paying off your mortgage early, first be sure that your lender allows paying additional principal without penalties (most do).

Here’s the bottom line. It may make sense to pay off your mortgage early when:

1) you would feel better about it psychologically and emotionally;
2) savings accounts, CDs, and other low-risk investments are paying low rates of interest;
3) you are a conservative investor and reluctant to invest in higher-return but higher risk investments; or
4) your house has lost value and the mortgage amount is higher than your home value.

Conclusion: The decisions aren’t as easy as they first appear, are they? Take time to weigh the arguments on both sides of the debate and take the road that will bring you greater peace of mind. It’s tough to put a price on “less stress,” but it is always high value.
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1I’ll refer to second mortgages throughout this section, but the information applies equally well whether you have a second mortgage or a Home Equity Line of Credit (HELOC).

2What good does it do to add a mast and a sail to your boat if you haven’t first plugged the leak in the bottom?

3Assuming, again, that you can earn a higher rate of return than the interest rate you are paying for the mortgage.

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