Could Your Debt Disappear?
Dear Rich Lifer,
What would you do with an extra $10,000 in the bank?
During his 2020 presidential campaign, president-elect Joe Biden promised to cancel hundreds of billions of dollars of student debt, starting with a $10,000 write-off for all 43 million Americans with federal loans.
Whether Biden fulfills his promise or not, the thought of wiping out billions of dollars worth of debt has stirred up debate among democrats and republicans.
But politics aside, let’s imagine for a minute you were given $10,000 to spend how you wish. And let’s also assume you have about $10,000 in outstanding debt.
What would you do with that money?
Conventional thinking says you should pay off all your debt. But, paying off a loan early is not always the best decision.
Click now to see the biggest prediction of this man’s 40 year career. (It’s about to affect 330 million Americans…)
Loan Repayment and Your Credit Score
There are several scenarios where it’s a bad idea to wipe out your loans early. Whenever you’re deciding to pay off debt early, think about two things:
How will this affect my credit score, and is early loan repayment the best use of my money?
Your credit score is influenced by five factors:
- On-time payments
- Amounts owed/credit utilization
- Length of credit history (including average age of accounts)
- Types of credit used
- New credit applications
Surprisingly, if you pay off your debt early, you can negatively impact several of these factors.
For example, let’s say you have one outstanding loan. If you pay it off ahead of time, you’ll have fewer on-time payments to register, you’ll lower your average age of accounts, and since you’ll have wiped out the only debt you owe, you also reduce the types of credit you’re using.
Sounds crazy, right?
We will say that this scenario is rare because most people have multiple lines of credit or several credit cards with low balances and high credit limits. If you were to erase one of these debts completely, your credit score would be fine.
It’s only when you carry one loan that if you were to wipe it out and not use credit for a significant amount of time, would your credit score drop – or worse, you may become “unscoreable.” Which means your recent risk factors are unknown.
Credit scoring algorithms can’t tell the difference between you losing your job and going to live in the woods for 6 months, or you having plenty of money and not using credit for 6 months.
The point is, paying down your debt early can impact your credit score, so beware of that before you make a final payment.
What Else Could You Spend That Money On?
The other question you have to ask is what else could that money go toward?
If you have dreams of early retirement or an alarmingly small emergency fund, it might be wise to invest that money instead of paying off your loan early.
There is one caveat though…
If you carry high-interest debt, like credit card balances, it’s generally best to pay those debts in full each month – or as much as you can afford to pay. When you carry a balance on your credit card, you increase your credit utilization, which lowers your credit score.
Credit card debt is typically the highest interest debt most Americans carry. So, instead of making an extra payment on your student loan or auto loan, redirect that money toward erasing your credit card debt and you’ll simultaneously improve your credit score and save on total interest charges.
What About All the Interest You’ll Save By Paying Your Loan Off Early?
The faster you pay off your debt, the less interest you owe. But it’s not uncommon for lenders to charge you penalties for paying off your loan early. Always read your loan contract’s terms and conditions.
If we assume there are no penalties, then yes, you’d save money on interest. And if that is going to help you sleep better at night, knowing you don’t owe anyone money, then this could be your best choice.
However, it’s worth looking into the “amortization schedule” of your loan since you might have already paid off most of the loan’s interest already.
This is especially true for mortgages. You pay most of the interest in the early years and pay mostly principal later on.
For example, let’s assume you have a 30-year mortgage of $300,000 with a 5 percent interest rate. Using an amortization calculator, we determine you’ll pay $1,610 per month. (Not including taxes and insurance.)
Based on the amortization schedule, you will pay $1,250 per month in interest payments at first. But toward the end of the lending period, your interest payments are much lower. By the time you have three years left on the loan, you’ll pay just over $200 in interest per month and it will continue to decline from there.
Based on this example, if you are late in a loan term, there’s not a huge advantage to paying off your loan early. You’re essentially borrowing money interest-free at this point, so you’re better off keeping your money and investing it somewhere else.
Deciding to pay off your debt early is not black and white. Consider where those funds might be useful and don’t ignore the impact on your credit score.
To a Richer Life,
The Rich Life Roadmap Team