Every once in a while, I like to listen to a little Dave Ramsey. And while I don’t agree with a lot of the things he says, I do concede that he does a good job of motivating people to pay off their debt. His secret is how simple and doable he makes paying off debt seem. Listen to him talk and you can’t help but feel like you’ll be able to crush any debt really fast.
Take the typical call he gets from someone asking about how to handle their student loans. It usually goes something like this.
Someone calls in talking about how they have some astronomical amount of student loans - $200,000 worth, for example. Maybe this caller will make a decent salary, $100,000 perhaps. Dave will then tell them that with a little grit and determination, they should be able to get out of it in just a few years. Live on $50k per year, throw $50k per year at the loans, and you should be done within four years. $200,000 divided by $50,000 equals four years. It sounds simple enough.
Of course, anyone who’s been in debt repayment mode knows that paying off debt isn’t quite that simple. There’s much more to it than just paying back what you borrowed. I find that when many people get started with paying down their debt, they get frustrated that it seems to be taking longer than it seems like it should.
That’s how I felt anyway. I made $110,000 as my starting salary out of law school. It still took me over two years to pay off $87,000 worth of student loans. With that income, it seems like I should have been able to pay off my student loans even faster than I did.
The issue is, when it comes to debt, you have two things that are going to slow down your debt repayment journey - interest and taxes. It’s good to understand the impact both of these factors will have on the speed of your debt repayment.
Paying Interest Will Slow Down Your Debt Repayment
It seems pretty obvious, but you’d be surprised at how many people forget or don’t seem to understand that they have to pay interest on top of their debt. The fact is, debt isn’t free. If you borrow money, no matter what, you’re going to have to pay back more than what you borrowed.
My own debt repayment story is a good example of how much interest can impact how fast you can pay off your debt. For me to pay off $87,000 worth of student loans, I had to spend $102,000. That’s a pretty big number I had to pay back - about 17% more than what I actually borrowed. And that’s with me paying off my debt just a few years out of school. If I had taken longer, I would have paid even more interest.
If you don’t know how interest works, it’s generally pretty simple. Just multiply your debt by your interest rate. That tells you how much interest your debt accrues in a year. If you have $100,000 worth of student loans at a 7% interest rate, you’re looking at approximately $7,000 worth of interest per year. If you really want to see how much your debt costs, try calculating how much interest your debt costs per day. To do that, just divide the total yearly interest by 365. You might be surprised at the number you see.
The key takeaway with all this is that paying off your debt doesn’t just mean paying back everything you borrowed. You’re going to have to pay back more than that. That’s why your debt will seem to take longer than it should to pay off. Throwing $50k per year at a $200k loan won’t get the job done in four years.
Intuitively, we all know this, but for some reason, a lot of us seem to forget how much interest can slow us down.
Paying Debt Requires Using Your After-Tax Money
The other thing that most people forget about debt - and what I think really makes it a pain to tackle - is that debt has to be paid with after-tax money. If you’re an aggressive saver with your pre-tax retirement savings, you’ll find that you’ll be able to accumulate money pretty fast. It’s not so difficult to build up savings when you’re able to save all of it without having to pay the government first.
The same isn’t true with paying off debt. Writing a $1,000 check doesn’t actually cost you $1,000. You have to remember that you first have to pay state and federal taxes, as well as FICA taxes. This can add up to a lot of money - and it means less money that you can use to throw at your debt.
Writing a $1,000 check really requires you to earn more than $1,000 to have $1,000 to spend. That’s a pretty significant difference that’s going to dramatically slow down your debt killing abilities. Even worse, when you’re in aggressive debt repayment mode, you can’t really do much to reduce your tax liability since you need all of the money you can get your hands on.
What Can You Do?
Given these two things that are killing your debt repayment ability, what’s can you do? Here are my thoughts:
- Refinance Your Loans. You’ll pay less interest if you refinance your loans down to a lower interest rate. If you’re in a position where you’re making a good salary and plan to pay off your student loans as fast as you can, it makes sense to refinance using a company like SoFi, Commonbond, or Earnest. Websites like Credible are also great ways to find lower interest rates. I wasted a year paying higher interest rates than I needed to simply because I didn’t know about refinancing my student loans. If I had realized it sooner, I could have saved more money and paid my debt off faster.
- Hustle To Pay Off Your Debt. Paying off your debt is going to be painful, no matter how you slice it. The key thing to remember is, the sooner you get rid of your debt, the sooner you’ll be able to devote more of your resources towards other goals. And when you’re debt-free, you’ll have so much more freedom to do what you want.
Your debt is going to be harder than you think to pay off. That’s just a fact given how debt works. You should recognize this and go into your debt repayment with eyes wide open. I’ve said before that paying off debt is never easy. But if you understand the obstacles that are in your way, it should be easier to stay motivated and stay on track.
It might take you longer to pay off your debt than it seems like it should. If that’s the case, you’ll at least know why. But stay motivated. If you keep at it, you’ll eventually get there!
Mrs. Adventure Rich says
I’m a big fan of paying off debt early… interest can take such a hit on your finances! And I never thought about the after-tax aspect, but you are right! Here’s to hustling away debt 🙂
Financial Panther says
It stinks when you’re in debt payoff mode simply because you’re forced to keep your income as high as possible in order to pay off debt quickly. I always think best thing to do is just crush that debt as fast as you can so you can get on with doing what you want to do.
Dave @ Married with Money says
Ugh interest and taxes, you’re telling me. I’m looking at what it’ll take to pay down our mortgage early and the interest is killer. I’m going to throw every dollar of side-hustle money toward it though, plus we’ll plan on paying it off within 20 years (instead of 30) maximum.
It’s easy to get discouraged, but setting up a system to just automatically take care of it – even slowly – will be helpful.
Financial Panther says
Making it automatic is definitely key. Keep it out of your hands!
“Your debt is going to be harder than you think to pay off.”
No kidding, I’ve been getting discouraged lately at how slow this process is actually taking me. It has been since March since I have been taking my debt serious and it is going to be a slowwww process.
Financial Panther says
Keep pushing at it though! Once you get through that wall it starts going faster.
FWIW, paying off debt can also be easier or quicker than you think because….1) You may get a promotion, raise and unexpected bonuses over the period of your repayment, allowing you to dedicate increased income to the repayment as long as you avoid lifestyle creep. 2) Mortgage and student loan interest are deductible up to a certain amount. The tax refund from this can go towards paying off more debt. 3) In fact, the majority of tax refunds should go to debt when you’re aggressively paying off debt. Ideally, you’d avoid a tax refund obviously, but lump sum payouts like tax refunds and bonuses make it really easy to take big chunks out of debt without much mental effort or discipline.
When I graduated with my bachelors, my initial loan balance was higher than my starting salary but my salary nearly doubled over the course of the 3.5 years that my debt took to payoff. I also made a rule for myself where 80% of all bonuses and tax refunds would go towards debt, and I allowed myself to spend the rest. So all in all, the outlook was pretty bleak when I initially started to payoff my debt, but it turned out much better than I expected. It taught me the financial discipline and frugality that will now allow me to retire early which almost makes the whole debt ordeal worth it since I learned an invaluable life lesson.
On a personal note, the hardest thing for me when paying off my debt is: the opportunity cost of my capital.
As an optimist – I see investment opportunities everywhere (not always a good thing).
I want to pay off my debt, but my natural inclination to want to outperform the interest rate of my debt – makes paying off my debt harder than it seems.
Financial Panther says
The opportunity cost thing is a tough one for me to argue against and its the most common thing I hear when people say they don’t want to pay off their debt. It’s tough because in hindsight, we can see we can make more, but who knows what the future holds. If I hadn’t paid off my student loans, I’d be sitting on over $100k in investments right now. But I always see that in hindsight. I really didn’t know what the future would hold.
House of Banks says
I really like your article. I agree with most things mentioned above. I personally prefer to pay off debt as soon as possible. It also depends on situation, size of debt and many other factors.
Financial Panther says
For sure – personal finance is personal. For me, paying off my student loans has opened up a lot of opportunity for me, simply because I have that anchor off me.