When paying off debt is a bad idea

By Liz Pulliam Weston

American households are staggering under near-record debt loads.

We have less equity in our homes and bigger balances on our credit cards than ever before. Bankruptcies continue to hit new highs, foreclosures are setting modern records and a big chunk of our disposable incomes pays for stuff we bought long ago.

Could anyone sensibly argue that now is not a good time to pay off your debt?

Yes, and that person is me -- the one who is usually telling you that debt is Financial Enemy No. 1 for many Americans. I haven't changed my mind about the importance of getting, and staying, debt-free. But I've seen enough examples of people who are taking the wrong approach to paying off their debts, and doing more financial damage to themselves in the process, that it's time to speak up.

Here are some examples of when it's not good to pay off what you owe:

1. When you're targeting the wrong debt

Many people are convinced that they should increase their investment in their homes by paying down their mortgages. Several readers have told me the great satisfaction they get from sending extra payments with their regular mortgage checks. Others are opting for 15-year loans instead of the standard 30-year variety so they can pay off the note more quickly.

It's so much nicer, they say, to see their loan balances dropping than it is to watch their other investments buck and pitch in today's difficult stock market.

Unfortunately, in their rush to free themselves of their home loans, many of these would-be Mortgage Terminators are ignoring other debts and obligations that ultimately will cost them more.

It makes no sense, for example, to speed up paying off low-interest, tax-deductible debt if you've got any other kind of debt -- credit cards, car loans, personal loans, student loans, you name it.

When it comes to paying off balances, your first goal should be to pay off your highest-rate nondeductible debt. Only after the credit cards, personal loans and car loans are retired should you even consider prepaying a deductible student loan or business loan. Mortgage interest is typically the last debt you want to pay. See "Don't rush to pay off that mortgage."

2. When you're neglecting your retirement savings

This one seems to be a hard concept for younger people to grasp. Surely they've got years to save for retirement. Why not focus on getting out of debt now?

It's because tempus fugit -- time flies -- and you can't get back an opportunity to contribute to a tax-advantaged retirement plan once you've let it slip away.

Say your employer matches half of your 401k contributions up to 6% of your salary, which is a fairly standard policy among large companies. If you make $40,000 but don't contribute that 6%, you're missing out on $1,200 of free employer money. Worse, that money and your missing contribution can't grow tax-deferred over the next 30 years. If they could, and they earned an average 8% annual return over the years, that one year's contributions could have grown to more than $35,000. Ouch.

You can try to make up for lost opportunities once your debt is paid off by making extra contributions to your retirement plans. But you can't get back the free money you passed up or the value of time in helping your money grow.

One of our message board participants gave us a good example of such finite opportunities. She had $250 extra each month and was trying to decide whether to pay off her car loan or fund a Roth IRA.

If she used the extra monthly cash to accelerate payments on a $20,000, five-year car loan, she could be done in just under three years, at an interest savings of more than $1,000.

In those three years, however, she would have forever missed the opportunity to contribute $3,000 annually to a Roth. Those contributions, by contrast, could grow to nearly $78,000 in 30 years -- or $140,000 if she could swing the $5,000 maximum contribution.

Continued: Using your retirement savings

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