Pay off debt or build savings?

Over at I’ve Paid for This Twice Already, Paid Twice invites her readers to think about the relative importance of paying off debt or building savings. Which should be a person’s top priority? It is, as she points out, not a clear-cut decision.

Some people say that there’s “good debt” (such as home and student loans, owed on property or training that eventually returns more than you pay…supposedly) and “bad debt” (everything else; especially credit cards). I personally would argue that there’s only debt, and debt is slavery. Debt forces you to stay in the traces until you pay it off or until you die, whichever comes first. Over at Debt Kid, Jessica describes experiencing the same revelation.

Freedom from debt is freedom to live as you choose. Period. If working brings you personal fulfillment, you can do it—and a debt-free worker is one who has a great deal more disposable income (to say nothing of more options) than one who labors under the lender’s lash. If you want to retire or devote your energy to low-paid but altruistic work, debt freedom will make either of those choices possible.

I’ve used savings—in direct contradiction of advice from money advisers—to pay off debt and never once regretted it. Here’s why:

1) Revolving debt cuts your purchasing power by the amount of the interest gouge. If you pay 18 percent for everything you put on a charge card, then each dollar you spend is really worth only 82 cents.

2) You don’t actually own anything when you’re making payments on it. The bank owns it; you’re just renting it.

3) For most mere mortals, the so-called tax benefits of mortgage interest are negligible.

4) If you own your home outright, the absence of a mortgage payment increases your real take-home pay enormously. I couldn’t live on my net income if I owed on my house or had to pay rent. I paid $100,000 for my first house, for which I put down $20,000. Until I paid off the loan, I owed $9,960/year on the PITI. In the best of times, that $100,000 earned $8,000 a year in mutual funds. Paying off the mortgage freed up $830 a month for living expenses and savings. Taxes and insurance on my present house, purchased with the proceeds of the sale of my first paid-off home, are about $2,200 a year, meaning that today I have to set aside about $183 a month to cover those annual bills. That’s a far cry from an $830/month bite…which at the time I paid off the loan represented half my monthly take-home pay.

5) Where real estate is concerned, in normal market conditions (which one day will return), when a house is paid off and appreciating in value, the money you put into it is growing just as it would grow in a conservative investment, at about 6 to 8 percent a year. Thus the $100,000 I paid for my first house yielded $211,000 a few years later, allowing me to buy my next house in cash. Once a house is paid off, you’ll never lack for cash to keep a comparable paid-off roof over your head.

6) This is not true while you’re paying on a mortgage, because the mortgage interest eats up the gains created by the property’s appreciation in value. Over 30 years at 6 percent, a you’ll pay $115,838 in interest on a $100,000 loan; in other words, you’ll pay $215,828.45 for your $100,000 house. If you’d put that extra $115,838 in mutual funds over the same period, the compounding interest would have been paying you, not the bank. Paying just $200 a month extra against principal would cut your payback time from 30 years to 16 years and 3 months and drop your total interest gouge to $57,386.

7) Clearing off  debt opens the way for larger and faster savings. If you could afford to make a payment on a car, a house, or a credit card, then once you’ve paid off the debt you can afford to put the amount of the payments directly into savings and investments.

So, in a way, debt pay-down is a form of saving.

On the other hand, in recessionary times when one’s income is at risk, you need a substantial emergency fund. If you find yourself starting out during a recession, your first priority obviously should be to stash enough to live on for at least six months, preferably longer. IMHO the ideal emergency fund contains one year’s worth of your present net income.  Once you have it, though, you’re justified in devoting every extra penny to paring down debt of all kinds.

In good times or bad, saving should be part of your agenda. But since freedom from debt makes your money go further and allows you to save substantially more, getting out from under debt should be your top priority.