Dean from Iowa wrote into The Ramsey Show asking an age-old question: should I prioritize paying down debt or generating wealth?
The 21-year-old has over $95,000 in student loan debt but says he doesn’t want to miss out on the opportunity to grow his wealth and utilize the power of compounding returns. He wondered whether he should simultaneously pay off his debt and invest for his future.
Dave Ramsey and co-host Jade Warshaw gave a simple answer in a clip posted Oct. 18 (1).
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“Here’s the thing, the compounding interest,” Warshaw began before Ramsey interrupted her to underline the importance of the point, “works on your debt, too.”
Compounding works both ways
Ramsey reminded listeners that compounding can work against you with debt the same way it works for you with investments.
“The only difference is the rate,” he said. “If you’re saving money at the same rate that you’re not paying off debt at the same rate, you have broken even exactly.”
And even if the rate of Dean’s earnings outpace his debt‘s interest, he’s starting with $0 invested, while his debt has a $95,000 head start.
The longer you wait to pay off your debt in full, the more money you end up paying the lender in interest. Carrying debt also locks up a portion of your income in debt repayment that could otherwise go toward investments.
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For Ramsey and his colleagues, debt is a creeping contagion that can infect your finances if you don’t take care of it as fast as you can. That’s why he encouraged Dean to take advantage of his youth and discharge his debt swiftly.
“You have lots of energy. Go use it. Go get you some money. You’ve made a mess and you need to clean up your mess,” Ramsey said. “Don’t be a wuss. Do it, man.”
The math favors paying down debt — most of the time
Are there cases where it makes sense to prioritize saving over paying down debt? The answer is yes. Debt can be useful or even valuable if it’s used the right way.
Student debt is paid for in future earnings, so it makes sense to pay it off with your present earnings as quickly as possible. The sooner the debt is paid, the more earnings you have to put toward savings and investments. If you make paying it off your priority when your earnings are small at the beginning of your career, you have more to invest when you’re making a lot mid- or late-career.
Debt with high-interest rates, such as credit card debt, can be a big money siphon, so you may want to dispose of it as quickly as possible.
Mortgage debt is a bit different. If you get a fixed-rate mortgage, your debt in nominal dollars stays the same as your earnings potentially increase over time. In effect, you may end up paying less over 15 or 30 years if your earnings increase as time goes on.
One case where it often makes sense to prioritize saving is if your job offers a 401(k) plan with an employer match. If your employer matches your account contributions up to a percentage of your salary, that’s essentially free money, and part of your compensation as an employee.
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The Ramsey Show Highlights (1)
This article originally appeared on Moneywise.com under the title: Dave Ramsey tells Iowa man, 21, ‘don’t be a wuss’ and focus on paying off his $95K debt before investing. Here’s why
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