Many financial gurus advocate paying off debt immediately so that you can get to work building a savings. This strategy sounds good on the surface, but it isn't always the appropriate financial move. Racking up debt is simple when you're young, but learning how to get out of debt quickly is normally a slow and cumbersome process. Credit cards, student loans, and even your mortgage make it tricky to build up a huge savings.
The Debt Snowball
There are many types on the "debt snowball" idea. But, they all have one thing in common. The idea depends on you starting with one debt, paying off that debt, and using the freed up capital to the next debt. As you pay off debts, the amount of "free" capital you have increases, which makes it much easier to pay off each following debt. This is the "snowball" effect. It's certainly more of a "savings snowball" than a debt snowball since its your savings that's increasing, not your debt.
For instance, lets say you have these debts:
Credit card - $50/month
Credit card - $100/month
Personal loan - $300/month
Mortgage - $600/month
If you pay off the first credit card, then you'll have an extra $50 to apply to the larger credit card. As soon as that credit card is paid off, you can utilize the $50 from the first credit card and the $100 from the second credit card to the personal loan. There's nothing inherently wrong with this approach, however it's not the only way to get out of debt fast. As a matter of fact, it might not even be the most efficient.
Another option available is to learn how to get out of debt utilizing debt arbitrage. The idea behind debt arbitrage is that you can obtain more in your investments than what your debt costs you. So long as the money you free up is invested, you can overcome the interest rate you're being charged on the new consolidated loan. Remember, after you've refinanced your debt, you're still paying the normal monthly payments. If you have combined all of your debts into a new mortgage utilizing a cash-out refinance, as an example, then the loan will be paid off based on a set schedule, so don't fret about never paying off those credit cards.
At the same time, you'll be putting that freed up capital to work. If your new consolidated loan have an interest rate of 5 percent, and you are spending your savings at 6 percent, then you'll always earn a lot more than what your debts are costing you. In fact, if you do the math, you can earn up to 2 percentage points less than your loan interest rate in the event that your investment is tax-deferred and generating compounded rates of return. The tax-deferral as well as the compounding make up for the fact that you're loan interest rate surpasses your investment interest rate.
When your accumulated savings equals your remaining debt, you employ your savings to pay off the debt in full. Mainly because your regular monthly payments continue to lower your total outstanding debt with each monthly payment, and you're concurrently building a savings, you could retire your total debt load quicker than if you had used the "debt snowball". You can even choose to carry the debt for an extended period of time, and continue to build your savings As long as you're earning more on your investments compared to what you're paying in interest, you will always come out ahead.
The sole way to know if this arbitrage strategy will work for you is to contact a financial planner and create a financial plan. Run some numbers and see which technique of paying off your debt works best for you.