Existing Debt is a Sunk Cost

One of the largest contributors to fishy accounting and sub-optimal financial decision making is debt.  This applies to all kinds of debt and whether or not you consider it to be “good debt”.

I’m not here to answer the endlessly debated question of whether or not to pay a mortgage off early (spoiler: probably not), but instead to provide a framework to help make that kind of decision for yourself.

The most important thing to remember is that the debt is a sunk cost.  Why you have the debt, where it came from, and whether or not going into debt was a good idea are irrelevant at this point in the game.  All of that is in the past and should no longer impact the decision making process about what can be controlled going forward: the present and future.

The Sunk Cost Fallacy

I would be amiss to mention sunk cost without explaining the sunk cost fallacy.

I like Wikipedia’s example of a non-refundable ticket to a sporting event to help explain it, but I’m going to tweak it a bit.

Let’s say you purchase a $50 ticket to an event in the future (Event #1).  Leading up to the event, you happen to win free tickets to a completely different event at the same date and time (Event #2)!  Both events are perfectly equal in your eyes, so it’s not possible to simply pick your favorite.

Both tickets are completely non-refundable, non-transferable, and completely worthless if you don’t use them yourself.  You’re now left with two options:

  1. Attend Event #1
  2. Attend Event #2

The sunk cost fallacy says that people may be more inclined to pick Event #1 because they already spent $50 towards the experience.  In reality, that $50 is gone regardless of which option is chosen!

The $50 in this case is the sunk cost and the fallacy is choosing Event #1 simply because it was the ticket you paid for.

Keep in mind, it’s not that Event #1 is the wrong choice, it’s simply one of the two equivalent options that were laid out in this example.  Either one is correct, but the fallacy is factoring the $50 sunk cost into the decision.

Would you feel obligated to attend Event #1 because you spent $50 on those tickets?

If so, what if I changed the situation so that Event #2 would be slightly more enjoyable than Event #1.  Does that change your decision? (hint: it should)

Treat Your Debt Like the Sunk Cost It Is

If you currently find yourself in debt, try to forget any of the baggage related to the who, what, why, where, and how answers to the origin of that debt.  This may be very difficult!

Debt and the corresponding payments that go with it are often a reminder of the past.  Past decisions, past situations, and past circumstances that you might not be a big fan of.  Paying off this kind of debt can feel freeing because it separates you from the past, but it still doesn’t change the past.

Don’t let past experiences negatively impact your financial situation from here on out.


Plan Beyond Being Debt-Free

Much like achieving financial independence, paying off your last dollar of debt isn’t the end game.  In fact, being debt-free isn’t even a prerequisite to achieving financial independence!

Life will continue onward after either of these accomplishments, so its important to consider what that life might look like ahead of time.  Don’t focus so strongly on one of these goals that you find yourself at the finish line asking: “What now?”

Envision your ideal future life first, then optimize your financial decisions to achieve that goal.

To butcher an old saying: Don’t let the financial goals wag the life.

If you are currently increasing the gap between your income and expenses to help pay off debt faster, I doubt you will immediately fall back into a paycheck to paycheck lifestyle once you finish.  What might a new goal in that next phase of life look like?  Focus on that instead of the debt itself once you figure it out.

Pretend You’re Managing Someone Else’s Finances

If all other reasoning fails, try to take a step back and take an unbiased look at your own situation.  Hold yourself to the highest fiduciary standard and “advise” yourself as to which financial decisions will help you reach your ultimate goal in the most efficient manner.

Let’s say you crunch all of the numbers and come up with the following options:

  1. Reach the goal in 8 years
  2. Reach the goal in 10 years
  3. Reach the goal in 12 years

Which one do you choose?

Option #1 of course!

What if I told you option #1 involved still being in debt when the goal was reached?  What if option #1 involved taking out even more debt?!?

If your answer changes in either of those scenarios, then you may not be treating debt rationally.

Debt is Just One More Variable

The goal of this post is to help you think of debt as just another variable in your greater financial picture.  Existing debt isn’t good or bad, it just is.

If you have trouble looking beyond paying off debt as your primary goals, then I propose you change the goal to increasing your net worth.  A larger net worth can provide far more options than smaller debt, including but not limited to: paying off debt once you figure out those bigger and better goals.

I chose not to include any math above because the math is simply the math and many words are spread across the internet explaining it.

Once you set your own goal, crunch the financial numbers for your own situation and choose the option that helps you get there most efficiently.  That path may involve killing your debt as soon as possible or it may involve making minimum payments for decades to come.  Either way it’s still the best option.

Treat debt rationally to help achieve your financial goals sooner.

2 thoughts to “Existing Debt is a Sunk Cost”

  1. We are debt free (barring mortgage), but we’re picking more of an option 2 ourselves. I’ve cut back my hours, which means cutting back quite a bit of income, and we still do travel / eat out quite a bit, so our FI date is a number of years further out than if we tightened our belts to the max and focused on squeezing out every dollar of income available. But we’re enjoying ourselves much more along the way, so it’s totally worth it. I’m guessing you’d agree thanks to this epic gap year adventure you two have embarked on ?

    1. I didn’t make it very clear above, but the options of various years above were assuming lifestyle stays constant. Basically, holding spending, lifestyle, etc. constant, you should use your excess money each month towards the most efficient investment, whether is it debt or otherwise.

      As you’ve gathered, we’re big fans of improving lifestyle now even if it delays our FI date. Sounds like the changes you’ve made are a big improvement in lifestyle, so you’re not going to get any complaints from me.

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