Here is the financial question of the week: Should I use savings to pay off a loan?
I always answer these questions with the number one goal in mind of helping you to retire early. That’s what this blog is about. If you want to retire early, you need a plan in place, and then you’ve got to stick to the plan.
Each situation is unique, but my experience with paying off loans with your savings is it gets you nowhere really fast. The reason for this is you are constantly hitting the reset button on your savings.
If you want to retire early, you are going to need the finances to do that- either save more money or make more money (or a combination of both). So I would tell you not to use your savings to pay off your loan. But this answer could change depending on the interest rate on the loan and a couple other factors.
Watch this video we put together where we answer this very important question someone asked us about whether they should use savings to pay off their loan and then read the post below for real life examples!
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Real life example of someone who paid off their loan debt with their savings
Let’s look at an example of someone who used their savings to pay off their loan.
This person felt anxious about a new car loan and wanted it completely paid off. So they took $25,000 from their retirement fund earning about 7% in index funds, and they used it to pay off the remaining balance of the car loan. The car was financed with a 3.9% loan.
What happened when they paid off the loan?
The pro is they have immediate gratification that the loan is paid off. There’s no more hassle of making payments and one less bill to worry about. The con is they just tied up $25,000 they can’t get back! Let’s say they really need that money for an emergency someday. Their savings is no longer building (they just went back to square one). On top of that, they may have to pay taxes on any capital gains when they cashed in their investment.
Sure, it might have felt good in the moment to pay off the car loan debt. Paying it off might provide a temporary feeling of relief. But in 20 years, that same initial investment of $25,000, would eventually be worth around $96,742 with compounding!!! And that’s with adding nothing more to the initial balance of $25,000.
The emotions behind wanting to pay off a loan
In the above scenario, relenting to fears about having outstanding debt actually establishes the bad habit to always pay down debts and never build up savings.
Building up savings takes patience and time. Again, you have to know your end goal. If you decide now to retire early, then you can stick with a long term savings plan and NEVER touch your investment account.
My experience is you will never replenish your savings if you use it to constantly pay off loans. The problem is much deeper than simply having a loan that needs to be repaid. The problem might revolve around anxiety towards money. It’s important to discover those issues early so you can make better financial decisions.
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Tips for staying the course with your savings
It’s not easy to stay the course with your savings, but if you put planning in place, it can be. Here are some tips to help you continue with your savings plan:
- Set up a totally separate account for your investments and make it difficult to withdraw from the account. You can manage your investments all in one place such as Personal Capital.
- Do not have a credit card tied to the account. Make it so you would have to sell out of an investment (think about your decisions).
- Make saving automatic. Have a set amount withdrawn from your paycheck to go right into this separate investment account. Use an app like Acorns to help you save every time you spend.
- Shop loans for lower interest rates. Super Money Loans is a great place to shop all kinds of loans.
- Make financial decisions with your spouse and have a combined plan. Use financial software like Quicken to record your expenses and create reports. Share this article with them and decide what works for your family.
- Educate yourself about investing and take charge of your money. Use a service like the Motley Fool to slowly learn about the stock market.
How you can have “good” debt and retire early
Let me tell you, it is possible to have what I call “good debt” and retire early and live off of your savings.
I purchased a house using financing and choose to only make the required payment each month. I consider this “good debt” because while it builds my credit score, I am also watching the home appreciate in value as the years go by. So yes, while I will end up paying interest on the loan, the value of the house is steadily climbing.
Now this type of performance is not guaranteed, and I am not a financial expert. There is always a risk when you buy something on credit or invest in a market, but when you look at long term trends, and do your homework ahead of time, you can usually make a profit. Make sure to speak with a financial professional if needed.
Think and do your research before you act with your money
The main take away lesson from this post is to always do your research and talk to financial professionals before making knee jerk reaction decisions.
Paying off a loan just to sleep better at night indicates you are living from a place of fear with your money, and you most likely have a hard time getting ahead. Take the opportunity to work on your reactions (when feelings of lack come up), and empower yourself with options. The long term markets are not all that scary to invest in. Slow and steady wins the race to financial independence.
Do you have an outstanding loan that is driving you crazy? What could you do to set up a financial savings plan which would help you feel more secure? Comment below!
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