5 Reasons NOT to Pay Down Debt

January 31, 2013

One of the most common things we help people with is paying off debt. This makes sense because in the case of high-interest debt like payday loans and most credit cards, you can save considerably more in interest by making extra payments towards that debt than you’re likely to earn by investing that same money instead. Paying off debt can also improve your credit score and cash flow. But are there times when it may make sense NOT to pay off debt? Here are a few:

You’re Planning to File for Bankruptcy

If your unsecured debt (like credit cards) is going to be wiped out by bankruptcy, your hard-earned dollars are better used making sure you can make your home and car payments, keep the lights on, and put food on the table for your family. It may feel unethical, but the whole purpose of bankruptcy is to protect you from going destitute to make debt payments and credit card companies assume a certain default rate anyway. That’s one of the reasons they charge such high interest rates. Think of all that interest you paid as an insurance premium in case you were later unable to pay your bills and bankruptcy as your insurance payout.

The Debt is Really Old

According to the Fair Debt Collection and Practices Act, your debt can only remain on your credit report for 7 years after your last missed payment so if it’s more than 7 years old since then, you may feel a moral obligation to pay, but it’s not hurting your credit score. However, if you make a payment, it can reset the clock and re-appear on your credit report. (No good deed goes unpunished.) For that reason, you may even want to avoid payments on debt that are approaching that 7-year mark unless you can settle it completely. That being said, if you live in one of the few states that has a statue of limitations for delinquent debt that’s longer than 7 years and the deadline hasn’t run out, you may want to settle the debt to avoid a lawsuit.

In the following situations, you want to continue making the minimum payments on your debt, but might not want to pay it down early:

You Don’t Have an Emergency Fund

As important as paying off high interest debt is, it can be even more important to have at least some savings set aside for emergencies. Otherwise, you can find yourself in a situation where you can’t make your rent or mortgage payments and put your home in danger. How much savings you need before paying down your debt depends on your situation. Most experts say you ideally need a minimum of 3-6 months’ worth of necessary expenses, but that target can be temporarily reduced if you have easy access to credit and/or support from friends or family. (At the very least, financial guru Dave Ramsey recommends having at least $1k in cash.) If you start with a lower amount, just be sure to continue building up your emergency savings once your debt is paid off.

You Aren’t Maxing the Match in Your Employer’s Plan

No matter how high your credit card interest rate is, it’s hard to beat the immediate 100% or 50% return plus the ongoing investment earnings you can get on your money by getting your employer’s match. To see which way you come out ahead, enter the additional debt payments you can make into this Debt Blaster calculator to see how much interest you can save. Then enter those same payments into this calculator to see how much those savings could grow if contributed to your retirement plan and left invested over the same time period as it would take to pay off your debt. Compare the options and pick which one saves or earns you more money.

The Interest Rate is Really Low

If the interest rate on your debt is below 6%, you can probably earn more by investing your savings even without a match rather than paying your debt down early. That’s why mortgages, car loans, and some student loans are considered “good debt.” In the case of mortgages and in certain cases, student loans, the cost of that interest is further lowered by being able to deduct the interest from your taxes. For example, if your mortgage interest rate is 4% and you’re in the 25% tax bracket and itemizing your deductions, it’s really only costing you 3% after the tax savings.

How about you? Are you unsure whether to pay down a debt or use the money for something else? Leave your question in the comments section below.