Paying off debt is a great feeling. Everyone likes a financial “win” every once in awhile and paying off a loan is an easy way to get one. That may not be the right move if you have low-interest debt.
Just Make The Required Monthly Payment
Even if you aren’t at the point where you can safely invest the money and make arbitrage profits, I still recommend that you do not pay off your low-interest debt.
Once you’ve paid off all debts above a 5% interest rate you should shift your focuses to the next stage of The Hierarchy of Personal Finance Needs: Financial Safety.
Build An Emergency Fund
If you aren’t sure what an emergency fund should look like then check out How To Build An Emergency Fund.
Once you’ve gotten yourself free from the burden of truly expensive debt, like credit card debt, your goal should be to never go back into that debt. The best way to do that is building up an emergency fund.
What If I Pay Off The Low-Interest Debt Anyways?
Potentially nothing. You may be just fine paying off the low interest debt, although if that ends up being the case you would have been better off investing that money for arbitrage profits.
On the other hand you could cause yourself to end up back in debt.
Consider This Situation
You have a car loan with a 4% interest rate. You really don’t like having to make that payment every month, which is completely understandable. You decide you want to pay if off faster by making more than the minimum payment.
In order to accomplish this you forego saving your extra money into an emergency fund and put it towards the car loan instead. After all, the car loan is costing you money in interest the longer you keep it.
Paying Off The Loan Early Can Have A Bad Outcome
By increasing the amount you are paying on your car payment you are essentially living paycheck to paycheck.
One day you make that final car payment. It is beautiful. You paid your car off a full year early.
As you run to go grab your phone to tell the world, you slip and break the fall with your wrist. You’re in a lot of pain and have to go to the doctor for an x-ray. As it turns out you have a fracture and will need a cast for awhile. Unfortunately you hadn’t planned for x-rays or casts in your budget.
You are forced to pay your portion of the expenses (assuming you are lucky enough to have insurance) with a credit card.
One month later the bill comes around and you don’t have the money to pay it off. Instead of saving for emergencies, you had paid off your car loan early. You now owe a 24.99% APR (interest rate) on the balance you failed to pay.
Moral Of The Story
While you could pay off low-interest debt early and be perfectly fine, life could also throw something unexpected at you.
The last thing you want to do is effectively trade out your 4% car loan interest rate for a 24.99% credit card interest rate.
Now you can see why you should build an emergency fund instead of paying off low-interest debt.
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