Editor’s note: After being alerted by Sharp Reader Steve, I went back and checked my numbers. I have included my corrections below.
In my earlier article on this topic, I wondered whether it made sense to pay down low interest debt, like car loans and low, fixed rate credit card balances. Last week, I finally sat down and ran the numbers.
and contrary to my conclusions in the previous article, I found out that it actually makes sense to attack the debt as aggressively as possible and then put money away to save, almost regardless of what the interest rate on the savings is. My numbers confirmed my theory, but also additionally show that even if the interest rate on the investment is less than the interest rate on the debt, you may still make out better in the long run by investing rather than most aggressively paying down the debt.
To figure this out, I made a Google Spreadsheet with 2 sheets of 6 columns each. I paired the 6 columns on each sheet into 3 groups of 2 columns each. The first two columns represented my car loan. The next two represented my credit card balance, and the last two columns represented my savings. The first column of each pair represented the running total of the account and the second represented the monthly contribution to the liability or asset:
|Car Loan||Monthly Payment Car Loan||Credit Card||Monthly Payment Credit Card||Savings||Monthly Payment Savings|
In the first cell under each of these I entered the initial condition. The running total was calculated by:
Rt = Tp*(1+i/12)-Mp
Rt = running total
Tp = previous total
i = annual interest rate (expressed in percent or decimal, 5% = .05)
Mp = monthly payment
In the case of the savings account, I added the monthly payment rather than subtracting it.
This is probably not exactly the right formula, especially depending on how frequently compounding occurs, but it’s close enough for our purposes.
Sheet 1 took the case where I put all of my extra money into savings and paid the minimums on the liabilities. The credit card account pays 2% of the balance each month, and as the monthly payment reduces, the difference from the initial payment gets applied to savings.
Sheet 2 took the case where I put all of my extra money into paying down the liabilities in the order of highest interest rate to lowest. When all debts were paid off, the total was applied to savings. In this case the savings doesn’t start for nearly one and a half years from now.
I set a savings goal of $80,000 (a down payment on a new house), and
Sheet 2 Sheet 1 beats Sheet 1 Sheet 2 by about six four months in reaching this goal at any reasonable a 6% savings interest rate s. It wasn’t until the savings interest rate exceeded 20% that Sheet 2reached the goal faster than Sheet1. Unfortunately, I don’t know if I can generate a 6% interest rate on such a short term cash goal. I originally used the 6% rate because it is higher than the debt interest rate and I was trying to see what happens with a rate higher than the debt rate.
In either scenario, the Sheet 2 won in the very long run by a few percent. This is a bit surprising.
So there you have it: Pay down low interest debt (aggressively) and THEN roll the cash that you had been spending on debt payments into savings and investment.
Conclusion: If you are trying to save for something in the short term, then it can still be real toss up between investing (saving) or paying down the debt. You will get to your goal faster by saving rather than paying down the debt, but when you get there you may still have the debt. However if you are saving for the long run, then even when the savings rate is less than the debt rate, you can still achieve overall savings by investing while you reduce your debt.