Investing vs Paying Off Debt
June 12, 2011
Investing vs paying off debt is a decision that many of us are faced with but we’d like to avoid. We’d rather earn enough money to both pay off our debt and save signifigant sums of money at the same time. Unfortunately, that’s not the reality for many of us.
Your Burden of Uncertainty
If you’re anything like me, then your finances probably feel like a constant tight-rope walk. It’s like in Monopoly when you’re not sure if you should build more houses or wait until you make it past the other players hotels first. That in-between feeling can be one of the most difficult things to deal with in mapping out your financial future.
I always say when playing Texas Hold’em that I want my hands to be either really great or really bad so I don’t get caught in between. Of course there’s a lot more (hopefully) on the line when it comes to balancing savings with debt repayment. This post will discuss some of the things you might wish to consider when determining how to allocate your resources between paying down debt and wealth building.
Balancing Investing With Paying Off Debt
For those of you who are not yet familiar with my story, my wife and I both currently earn decent salaries, but we also have a combined six figure student loan debt obligation. Tired of the debt/savings guessing game, I recently met with a financial planner to discuss the issue of balancing debt with wealth building. I suggest you meet with your own expert, but I wanted to address some of the concerns I was advised to consider when allocating resources. I am twenty-seven years old, and of course everyone’s balance of debt repayment vs. wealth creation will be different. But I think this will remind you of some of the factors to consider.
The Biggies: Age, Salary, Debt Load, Retirement Age
These factors shouldn’t shock anybody as they’re pretty standard considerations. When considering how much money to allocate to debt repayment, you should have an overall goal of when you wish to retire and the type of lifestyle you hope to enjoy once you do retire. Your age, salary and debt-load will all be factored in to determine the achievability of your investing goals.
Interest Rate on Debt
Another factor you will need to consider is the interest rate attached to the debt. Obviously if you have burdensome credit card debt, then it might be best to forego wealth creation–because it is unlikely you will be able to earn a higher rate of return on your investments than you owe on your credit cards.
Other Debt Factors to Consider
Is your debt dischargeable in bankruptcy? Does the debt provide significant tax benefits? How about this important question: are you able to meaningfully consolidate your debt or perhaps convert it into a user-friendly home equity line of credit? You need to know everything you can about your debt to determine how quickly you should try and pay it off. You must also consider how many years you have left in your payoff schedule.
Do You Have An Emergency Fund?
It’s always important to remember that when you pay debt off in advance, you are possibly taking away your ability to fund a future emergency. For example, my student loan debt repayment is $1,500 per month. That amount will be consistent until the day I pay the debt off in full. If I pay an extra $5,000 towards my principle, it only changes the repayment schedule timeline, not the monthly payment amount. So, even if I paid an extra $5,000, the next month I will still owe $1,500 for my monthly payment.
What I might not be able to do, however, is now survive a job loss. Consider also the flexibility of your debt. Federal student loans are often very flexible in terms of changing your repayment schedules or if you are seeking forbearances or deferments. If you lack an emergency fund then are there other means of support such as help from your family if things ever took a turn for the worse?
Small Window of Opportunity for Retirement Savings
Remember that you only have a small window when it comes to maximizing your retirement savings. In your twenties, you have a once in a life-time opportunity to make your money go further by investing as much as you can into your retirement funds now. The miracle of compounding interest should then help take care of the rest. The financial planner that I spoke with recommended that my wife and I pay $4.00 towards savings/retirement savings for every $1.00 that we put towards paying off our (massive) debt early.
Your Level of Comfort With Risk
As stated above, your comfort with investing risk will determine how much money you mentally need to keep in savings. It will also affect how aggressive you will be in choosing your investment allocation. Generally, investing in more aggressive stock-heavy retirement plans will lead to a higher rate of return and thus make the path to retirement easier.
Employer Match
If you receive a 401(k) match or other similar benefit, then you are really “throwing away free money” if you do not maximize that benefit each year. This too is a consideration when balancing investing with paying off debt early.
Conclusion
As I stated at the beginning, this is by no means a complete list; but I wanted to go over some of the basic factors you should consider when sitting down to map out how you will balance investing/savings with paying off debt early. What other factors would you personally consider in reaching this determination? How do you personally balance investing with paying off or paying down debt?
All posts by Chris Thomas
I have decided to pay off debt at the rate of 25% of my income, then start investing in CDs, probably. My credit card debt is at a rate of 12% so I believe it would be wiser to get rid of it first.
Very timely post. I have tried to balance this as much as possible and have chosen to eliminate my student loan debt first. I only had $10,000 left to repay at that point and now I’m only a few months from finishing. I still owe my parents some money, but I am 26 and will look to achieve a much higher savings rate when my student loan is paid, rather than paying back my parents quickly.