I have always had the notion that to be debt free is to have zero debt. With the rise of interest rates and the ability to have high yield savings accounts, there has opened an interesting opportunity to be net debt free. So, what is net debt free? When you have enough money set aside to be able to wipe out your debt at any time. Most of our debt is currently at interest rates between 2-4%. They were taken out before the rise of interest rates. Recently I opened a high yield savings account that is currently paying out a whopping 5% return. My wife and I got into a debate about snowballing our debt vs building extra savings. She was arguing math, and I was arguing security and peace of mind.
Her math argument is that as long as the interest rate of the savings account is higher than the debt, we should throw the minimum at the debt and the maximum at the savings account because 1) The savings account interest is out pacing the debt interest rate and 2) there could be a greater investment available in the future and we can always pay off the debt whenever we’re ready.
The security and peace of mind argument is that 1) the actual interest being paid for the debt is higher than the savings interest earned until the savings balance is close to the amount of debt and 2) while there is good intention to dedicate the money from the savings account to debt, there is no guarantee that that interest we are earning will go towards paying the debt and if not, we could be further from goal then if we just snowballed it in the first place.
To really put it into perspective we must see the difference between the scenarios:
If you have $100,000 in debt at an interest rate of 3.5%. At a $500 minimum payment it will take you 25 years and you will pay $50,299.30 in interest for a total of $150,299.30 over 25 years.
Scenario A – If you double the payments to $1000, you will pay $18,403.70 in interest for a total of $118,403.70 over 10 years. You are getting debt freedom 15 years earlier and saving $31,895.60 in interest payments. If you then put the full amount into savings for the remaining 15 years you will have $267,288.94. That is a net total of $148,885.24.
Scenario B – If you put the extra $500 into the savings account at a 5% interest rate. At that same 10-year mark you will have a debt balance of $70,118.24 and a savings account balance of $77,641.14. After 25 years you would have $297,754.85. That is a net total of $147,455.55.
Combining the best of both worlds would be Scenario C – If you use the savings to pay off the debt after 10 years AND throw the full amount into savings afterwards. That will give you $282,131.37 after 25 years. That is a net total of $152,013.13.
These scenarios assume that:
- Saving Interest rates would remain constant at 5% for the next 25 years.
- You will have the discipline to continue allocating that $ to savings after you are debt free.
- There will be no life circumstances over the next 10 years that would cause you to stop or reduce payments.
In the end the one you can do the most consistently for the longest period will be the best bet. So which scenario would you choose?