Is Paying Off Debt Like Saving?

I’m often amazed how some people feel they aren’t saving much of anything.  Then I ask them about how much are they paying off in debt.  That is often a big number, so I point out that debt repayment and saving both increase your net worth.  So in some regards debt repayment is the same as savings.

For example, I’m focused on paying off my mortgage right now. I’m currently doing my regular payments plus lump sum payments just about every month.  Does that mean I’m not saving anything in a month?  I personally feel its the same, since having no mortgage is just as critical to my plan as having a good size pool of money invested.  Yet on the other hand, are you really saving if you are just making the minimum payments on your credit card bill?  In this case the increase of your net worth is minimal so you could potentially argue that it isn’t like saving.

Thus we can be into a interesting paradox where some debt repayment could be like savings, while other debt repayment may not be.  So what debt repayment is like savings?  At this point it might be easier to take a step back and determine one of the core tenets of personal finance: are you spending less than you earn?  Yes? Good.  Now are you still spending less than you earn if you consider interest payments as spending? Yes, good job.  No, then you are not saving overall.  In the end if your interest payments shove you over what you make in a month you are in a debt spiral.  Your debt will continue to grow regardless of your ‘savings’.  So you would need to take drastic action to free up enough cash flow until you are spending less than you earn.

In the end, paying out debt might be like savings but in general I would say that only really applies if you are making significant payments towards the principle.  Otherwise if 95% of your payment goes towards interest, calling it savings is deluding yourself.  But what if it is tax deductible debt?  The math gets more complicated to determine what you are paying in interest on a net basis, but ultimately the same idea applies.

So would you call debt repayment the same as savings?  Also does it matter where the debt came from?

7 thoughts on “Is Paying Off Debt Like Saving?”

  1. You are right, interest expense is an expense and reducing your debt is savings.

    Easy way to check if you paid your debt over a period is to see if the balance went up or down!

    If your amount owning on the credit card went from 15,000 to 14,950 then you saved $50 regardless of whether you paid $500 to Visa.

    Last quarter my mortgage went down about $2,500 even though I pay $1,200 per month. That means I paid $3,600 but only saved $2,500 — the rest went to interest.

  2. I think the key is to focus on net worth … if that is increasing you know that your debts are down, your savings are up or a combination. I started tracking my net worth about 18 months ago and have found it to be the most powerful motivator for me personally.

    Having said that it is not perfect as last month my stock portfolio took a hit that effectively decreased my net worth for that month. Yet I know my cash and near cash holdings increased.

    Generally I agree paying off debt is essentially the same as savings.

  3. I think debt repayment which goes towards a loan backed by a tangible asset such as a house or a car is different from debt repayment towards credit cards or student loans. Both improve your net worth because a balance sheet’s liability is lessened but only the former includes the increased net value of an asset.

    If the interest is tax-deductible, it only lessens the after-tax interest expense. If you pay $1,000 in credit card interest, it will be $1,000 in after-tax dollars. But $1,000 in home mortgage interest will end up being several hundred dollars less in after-tex dollars.

    Your “95% of your payment…” remark might be more true for short-term debt such as credit cards. But for home mortgages, that is pretty typical for the first few years but as the years go by the percent going to principal increases and at an increasing rate.

    Then again, I have been debt-free for 12 years so I barely remember what it was like to pay interest on anything. 🙂

  4. All other things being equal, paying off debt is the first priority in becoming financially independent. There is a negative compounding effect when it is not paid off. Dollars that go toward interest payments are not available for savings or investment.

    On a balance sheet “debt is debt”. The dollars are cold blooded and don’t care why they are owed.

    One can calculate the interest that is “saved” for each $1 of mortgage one pays off early. Savings can also be calculated in today’s dollars.

    Example…$1 at 5 % over 20 years is equivalent to $2 saved with future interest that will not have to be paid. Perhaps in-the-order of $1.50 in current dollars.

  5. Easy enough metric – are you paying more or making more in interest?

    Let’s say you have $500 to spend.

    You can either pay off some credit card debt, or invest it.

    If you’re paying 29% interest on the credit card debt. Then you’d have to find an investment that can earn at LEAST 29% to be equivalent to paying off that debt.

    Because debt doesn’t go away. You still have to pay it later. Even if you aren’t accumulating equity (like in a house), you’re still avoiding paying MORE later.

  6. Good points everyone. Thanks for your ideas.

    I think Canadian Money hit it on the head, the problem with debt is the long term costs.

    Deegee,

    I know what you are getting at, but at the same time I’m not sure if I ever paid over 95% towards interest even at the start. Mmm, I wish I had some records from back then to check easily, but I don’t. So I’ll have to give you that one.

    Tim

  7. Paying down debt (principal reduction) is exactly as saving. They both increase your net worth as you mentioned. Payments you make to interest charges can be seen as a discretionary expense. This you may or may not be able to control. Negotiate with your financial institution to get the best rate.

    Getting into more debt is something you want to avoid. That is the debt spiral mentioned above…

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