The Million Dollar Question of Personal Finance: Should I pay down debt or invest? What if you could do both?
Traditional personal finance tells us to choose between paying down debt or saving and investing. The conversation usually goes like this, “Does the interest rate on your debt exceed the returns you could get investing in the market?”
For example, if you have a credit card at 20%, it would be in your best interest, no pun intended, to pay off your credit card because there are not many investments which will return 20%.
In another example, if you have an auto loan at 4%, it might be better to invest your cash in the stock market or other investments because you can earn higher returns than 4%. The stock market has historically returned 7-8% on average over the last century. By investing in the stock market, you can theoretically grow your wealth 3-4% more than by paying off debt.
To pay off debt or save and invest is the million dollar question of personal finance. What can I do to prudently grow my wealth?
“Wealth is the ability to fully experience life.” – Henry David Thoreau
Benefits of Paying Down Debt
First, let’s start this section off by talking about mortgages: The word mortgage is derived from a “Law French” term used by English lawyers in the Middle Ages meaning “death pledge“, and refers to the pledge ending when either the obligation is fulfilled or the property is taken through foreclosure.
Literally, mortgage = death pledge. If you aren’t debting, you are dying… wait, that’s not the quote.
“A man in debt is so far a slave.” – Ralph Waldo Emerson
All jokes aside, debt is horrible: it is mentally draining, financially draining, and affects your entire life if you are weighed down by the large barbell of debt.
The main benefit to paying down debt is increased cash flow. No more giving your hard earned cash to those pesky lenders!
If you choose to pay down debt, you will want to put extra cash towards your debt each month. This will increase the speed at which you pay down your debt. By sacrificing short term and putting extra cash towards your debt, you can eliminate those debts in a much shorter time frame. In addition, by paying off your debt faster, you will save money on interest!
Let’s do an example together.
Let’s say you have a $20,000 loan with a 6% interest rate and a 10 year term. Using an online calculator, your monthly payment will be $222.04. Over 10 years (120 months), this will cost you $6,867.01 in interest. If you pay $100 extra a month, you can cut the time you are paying off your debt to 6.25 years (75 months) and you will pay $4,008.09 in interest. By paying an extra $100 a month, you will save yourself $2,858.92 and will be debt-free 3.75 years ahead of schedule!
As shown above, by paying extra each month, you can save money and reduce the amount of time you are paying off your debt. In addition, once the debt is gone you effectively give yourself a raise; you have more money falling to the bottom line each month for you to save, invest, donate, spend, etc.
Benefits of Investing
“Risk comes from not knowing what you’re doing.” – Warren Buffett
Really, investing can be as simple as you want it to be. Investing is not gambling. Investing consists of buying assets which have value and have the potential to appreciate in value over time.
If you are interested in investing in the stock market, you have the capability to invest in low cost index funds. These index funds will “mirror” the market. As I mentioned above, the stock market has historically returned 7-8% on average over the last century. If you save $10,000 a year for 30 years and get 8% returns, you will have a portfolio worth $1.2 million!
Vanguard has many excellent options if you want to diversify index funds (domestic stocks and bonds, dividend growth stocks, international stocks and bonds, etc.).
If you don’t want to invest in the stock market, and would prefer to invest in rental properties, you can do that. There are many advantages to investing in real estate. Why do I love real estate as an investment class? Real estate is:
- Accessible – Anyone can buy it
- Appreciable – Can increase in value over time
- Leverageable – You can buy on margin and borrow against equity
- Rentable – Cash flow baby!
- Improvable – Through sweat equity or contracting out
- Deductible/Depreciable/Deferrable – Amazing tax benefits
Or if you don’t want to invest in either the stock or rental market, you could start a blog and look to build a business online! There are 7 billion people in the world, do you think you can carve out a niche for yourself and your business?
Again, there are many investment strategies out there. Personally, I believe rental properties offer many long term wealth building benefits. I also believe there are many benefits from holding low cost index funds.
If you want to read more on investing, please take a look at the following books:
- How to Think About Money (book review)
- The Richest Man in Babylon
- The Millionaire Next Door: The Surprising Secrets of America’s Wealthy
- The 4-Hour Workweek: Escape 9-5, Live Anywhere, and Join the New Rich
- Money: Master the Game (book review)
- Think And Grow Rich
- The Intelligent Investor: The Definitive Book on Value Investing.
- How to Win Friends & Influence People
- Rich Dad Poor Dad
What’s best for you?
Before asking yourself the million dollar question of personal finance, you should ask yourself the following questions:
- Do you have enough money each month to cover your debt? Do you have additional money at the end of each month to invest?
- How much debt do you have? What are the interest rates? Do you feel debt has a grip on your life or finances?
- If you have money, will you actually invest it? Or will you spend it?
- Do you have an emergency fund?
- What are the terms of your debt? Are there any penalties for prepayment? Is your interest rate adjustable?
Once you are able to answer the questions above, it will be easier to answer the million dollar personal finance question.
Remember the golden rule: he who has the gold makes the rules – Unknown
Now that you are an expert in investing vs. paying down debt, you can critique and help me with my decision to invest and pay down debt.
As I alluded to in my post, Coming Across New Opportunities, I have options in 2017 to do different things with my cash.
Currently, I’m contributing 4% to a Roth 401k to take advantage of my company’s match. After all deductions from my paycheck, I’m going to be able to save $3-4k a month. Here’s where it gets tricky. Having a pile of cash is never a bad thing, but ideally, you want your money to be working for you. Getting pennies in interest in the bank isn’t going to get me to financial freedom very fast!
I asked my readers to help me out with my decision. I asked, should I pay down debt, open an IRA, or open a brokerage account? Luckily, I was able to get some good feedback from two bloggers:
Max, who blogs at Max Your Freedom, suggested I pay down my mortgage to get rid of PMI:
Mustard Seed Money suggested I open a Roth IRA to take advantage of the tax benefits I’m offered as someone who makes less than $132,000.
I came back to the Million Dollar Personal Finance Question: Should I pay down debt or save and invest? I thought to myself, let’s see if I can do both…
“Life is like a bicycle. To keep your balance, you must keep moving.” – Albert Einstein
Erik’s 2017 Wealth Building Plan
I ran the numbers. The final tally is in. All bets are off. I’m going to reject all personal finance wisdom and do something crazy: pay down debt and save and invest!
Contribute the Maximum to Roth IRA
As Mustard Seed Money suggested, contributing to a Roth IRA would be a prudent choice for tax purposes. In addition, I have wanted to build a dividend/income portfolio for quite some time. Now I have the chance!
First, I needed to fund my account. Last January, my company gave us 20 shares of stock as a long term incentive. The shares vest over 4 years. The platform they issued the stocks through are Fidelity. Since I already had some shares vest, I opened up the IRA through Fidelity.
There is one thing unique about IRA’s: You can make contributions to the previous year up until March 31st of the current year. So that’s what I did! I could contributed $5,500 to my IRA, on the second to last day in February, and I can counted it as a 2016 contribution! Great success!
Now on to the fun part: figuring out what investments to choose. As I stated above, low cost index funds are amazing for individual investors who want to “mirror” the market and not pay ridiculous fees.
For me, I want to explore my options before I settle on a fund or strategy to invest. In addition, we are at the top of the market, hitting new highs each week! I’m not in a rush to find a deal at this point.
To recap, any low cost index fund is always a solid choice. I also believe dividend growth stocks have a lot of potential. Cash flow is king, and I’m looking to be the ruler! (Ha, I should stop trying to make up quotes 🙂 )
That’s that! I maxed out my contribution for 2016 and will look to put in $5,500 other the course of the next 10 months!
Get Rid of Private Mortgage Insurance
My PMI payment is $144 a month and I have a 2.625% interest rate on a 5/1 ARM Mortgage. The rate adjusts August 1st, 2021, so I have about 4.5 years to go until the adjustment. To get to 20% equity in my property (20% to get rid of PMI), I have to get to $241,800 principal balance. On the left hand side, I have calculated the extra principal needed each month to maximize my return on investment while also being able to save some cash for any investments or fun I want to pursue in the mean time.
On the right side, you can see the ROI calculation for the extra principal payments. After running the analysis, I realized there probably wouldn’t be an investment class which would guarantee 8.43% annual tax-free returns over the next 3.75 years.
Once I have accomplished paying down my mortgage to get rid of PMI, I will most likely go back to the minimum payment. A 2.625% interest rate on a mortgage is dirt cheap…
By having an abundance mindset and choosing to invest and pay down debt, I will allow myself to create cash flow opportunities on both parts of the income statement. I will be reducing my expenses by $144 a month for the next 3.75 years and increasing my retirement income.
Thank you to my friends for helping me out with my decision! I’m glad we could do this together. I really appreciate the comments I received on my Coming Across New Opportunities post from other personal finance bloggers, such as, Mustard Seed Money and Max. Also, thank you to Henry who solidified my position to go through with this. We work together and frequently go for walks in the Downtown Minneapolis Skyway – we chat about business, the blog, work, girls (what did you expect?! We are two single 20 something males!), etc.
I still have plenty of work to do. I have over $20k in extra principal payments in the next 8 months, and have $5,500 to contribute to my IRA for 2017. The work is never done until the cows come home (Okay, now I’m done.)
I look forward to paying down my mortgage and maxing my Roth IRA for 2017.
2017 will be a very exciting year, let’s hope it is fruitful for all of us! Cheers!
In 2017, are you looking to invest or pay down debt? Are you saving up for a big purchase? Are there any personal finance questions you would like us to touch on? Do you perform analysis on your finances like this?