Björn Berg answers questions by the readers of online news outlet Vísir.

A 25-year-old man asks:

One of the most important financial decisions we make during our lives is how we generally answer questions like this:

Should I pay down debt, or should I save the money?

In my experience, people tend to be in a much better financial position when they make debt repayment a priority, almost regardless of the situation.

Paying down debt is tax-free. Savings may be subject to capital income tax above the tax-free allowance. Debt repayment is also low-risk, since the part of the loan you pay off can never again be charged interest or indexation. You don’t need to decide which savings or investment option is best at any given time, and interest rates are high.

We should probably talk more about these rather excellent qualities of debt repayment.

Does it make sense to pay extra towards this loan?

Let’s look at your example, although we need to fill in a few gaps.

You mention an ISK 5 million indexed supplementary mortgage. At the time of writing, the interest rate on such a loan at Íslandsbanki is 5.65%. Indexed loans also carry indexation, and you refer to the current development of the index.

Unfortunately, there is no such thing as the current development of the index when we look ahead, because the future hasn’t happened yet. We only know how the index has developed recently, and that tells us very little about what comes next.

So, for this example, let’s assume inflation over the life of the loan is 3.5%, or about 1 percentage point above the Central Bank’s inflation target. Let’s also assume the interest rate stays unchanged.

You don’t mention the remaining term of the loan, but let’s say 15 years are left.

Based on those assumptions, the current monthly payment would be around ISK 41,500. The question is what you gain by paying an extra ISK 50,000 each month.

Let’s compare the two options.

Example 1: You do not make extra payments

If you only make the required payments, it will take you 15 years to repay the loan in full.

Over that period, the loan will cost you about ISK 4.8 million in interest and indexation.

Example 2: You increase the monthly payment by ISK 50,000

If you add ISK 50,000 to the amount you currently pay and keep that total payment fixed over the remaining life of the loan, you make sure you pay ISK 91,500 each month.

Now it takes you just under six years to repay the loan in full, not 15.

You’ve saved yourself nine whole years of a rather annoying supplementary loan knocking on the door every month.

On top of that, the total cost of the loan falls to about ISK 1.5 million instead of ISK 4.8 million. That means you save about ISK 3.3 million in interest and indexation.

But what about saving the money instead?

This shows very clearly why extra loan payments can be so powerful.

But you said you find it hard to see the benefit compared with putting the money into a savings account.

Historically, non-indexed savings accounts without a fixed term have produced little, if any, real return. In other words, they have often done little more than keep up with inflation.

Your indexed loan, on the other hand, carries interest on top of indexation. That means paying it down faster gives you a real gain.

We don’t know what interest rate you’ll receive on savings accounts over the life of the loan. But it would take rather unusual conditions for that rate to be higher than the cost of the loan.

To be fair, we have seen unusual conditions in the banking market recently. Real interest rates on non-indexed deposits have been unusually high. But it would be unwise to assume that this will last for long.

Why do we hesitate?

I get questions like this very often, so you’re certainly not alone in thinking about it.

Even when the benefits of prioritising debt repayment are quite clear, many people find it hard to shake the feeling that they may be missing out on other opportunities.

It can also be hard to see the effect of even a relatively small extra payment unless you use a calculator.

A lot of this comes down to how we think about money, returns and risk.

For example, some people find it difficult to sell shares in order to pay down consumer debt, while at the same time they would find it absurd to take out consumer debt in order to buy shares.

But in financial terms, those two situations are closely related. We’re often looking at the same thing from two different angles.

It matters to develop a healthy, simple and clear way of thinking about your personal finances, especially debt. Once you do that, the right decision often becomes much easier.

We don’t need to make this overly complicated.

Stay away from unnecessary debt, prioritise paying it down and trust that doing so will improve your finances over the long term.