Pay Down Debt and Invest? Erik’s 2017 Plan

Erik Financial Education, Thoughts of a Mastermind 31 Comments

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

To the average person, investing seems to be complicated. Just look at the list of terms Henry compiled in his post, K.I.S.S. – 8 Personal Finance Tips

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.

Financial Markets

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.).

Real Estate

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:


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.

My Conundrum

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:

comment from max your freedom blogger

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.

comment from mustard seed money blogger

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!

2016 ira contribution confirmation

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

After running the analysis of Max‘s suggestion and discussing with Henry, my new personal finance consultant, I realized getting rid of Private Mortgage Insurance would be a prudent thing to do.

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.

paying down mortgage analysis

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…


Conclusion

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?

Erik

Comments 31

  1. Well that was critical thinking applied to personal finance at its best! You’ve charted a very wise path. It’s always nice to have the luxury to order something extra from the menu when you really want to try both options. Great work Erik! And thanks for the acknowledgment, greatly appreciated! Max

  2. Thanks for the details Erik . Can’t argue with the homework you did to come up with your plan. Everyone’s situation will vary and best to get you number down, ask for advice and come up with the plan that fits. Our 2017 goal is to help our twin son and daughter cash flow college in the fall.

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      I read about your goal on your blog! It’s awesome you are helping your son pay for college.

      Thanks for stopping by and have a good day Brian!!

  3. I’m reading every word of your detailed and well thought out posts and absorbing as much as possible! We are in a similar position: do we pay down our debt or save money for investing in a home? I’m looking forward to browsing through the rest of your posts!

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      Thanks Mrs. Daisy for the compliment. I’m glad my content is helping people and I’m able to add value to others lives.

      Personal finance really is personal. It’s about asking the right questions.

      Thanks for stopping by! Have a good day 🙂

  4. I love the examples you gave-it makes it all sound easy :).
    Be sure that you know the exact requirements for the bank to remove PMI before you start putting your extra funds toward your principal. We had a very disappointing situation once where we paid a huge chunk of our mortgage to get rid of PMI only to find that they required it to be paid for 5 years minimum. I would request an actual document from them on getting rid of PMI, even though you’re not currently there yet. Likely, you’ll have to call to get that (they don’t make it easy for sure!). It’ll be a great ROI for you!

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      Thanks for stopping by MYMM, I’m glad I can break down seemingly complex ideas into simple ones.

      I’ll take your suggestion into consideration. That would definitely throw a wrench into my plans if there was a clause like the ones you mentioned.

  5. This is always the big question, isn’t it? I’d say, pay off all your debt and invest the rest! Of course, it’s never that easy. We’re fortunate to only have a few thousand left on one of our cars and the mortgage as our only debt. In all seriousness, the answer is usually to do both. if you have debt that is crushing or at an extremely high interest rate, then you must make that a priority over paying lower-interest debt or making big retirement contributions. If you have “reasonable” debt you’ll want to do both and focus your energy on the one that excites you most. Paying down debt or investing is still increasing your net worth. So, go nut! As long as you’re moving the needle in the right direction, it doesn’t really matter what you do first.

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      Completely agree with you. I think it’s great to do both at the same time if you can. Starting early and often will bring you massive gains in the future!

      Like you said, both are increasing your net worth. So why not?

  6. My wife and I do both, and for the most part we are able to take the emotion out of our debt paydown and hold onto lower-interest debt while investing instead. I’ve come to accept that for some people – perhaps a majority – emotions rule the day. In that case paying down debt is definitely justifiable.

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      Thanks DC for stopping by. Completely agree with you, people get very emotional about debt and their finances. Being able to take a step back from it and breaking it down is a great strategy. It seems you are doing very well with your choice! 🙂 Have a good one.

      1. It’s worked out the past few years, but I have to admit we are tempted to cash out some investments to pay down a bigger chunk of debt! I keep trying to talk myself out of it, though. Gotta pay off that low interest debt as slowly as possible!

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          I know what you mean DC… it’s a tough decision… 2.625% is dirt cheap, but at the same time, I don’t have anything else that will return 8% guaranteed other the next few years…

          I could just stay in cash though. Options…

          Thanks for the comment and stopping by!

  7. We balance both debt and savings in accordance with goals for each. So much like your pmi and max out the Roth approach. In our case I’ve not had pmi but it’s usually more around the amount of tax advantage space available versus mortgage payments. I.e. The question doesn’t go away in the later phases of wealth accumulation, the trade offs just change.

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      Definitely… As time goes on, I don’t expect things to get easier… which is why I want to work hard now to ensure I am successful later!

  8. It’s great that you are very thorough on your approach to analyze all the opportunities out there and chose the one that fits your philosophy. In terms of personal finance, you can be successful in many ways and you don’t have to do what everyone does.

    In my case, I am very comfortable with debt and my interest rates on my loans are around 3%. I believe that I can achieve a rate of return that’s higher and than 3% so I am in no hurry to payoff debts.

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      I hope it turns out well for me. While 25k is a lot of money, which would do great in the market, in the years to come, I’ll have increased cash flow and the possibility to invest in different products OR quit my job and start a business.

      Thanks for stopping by Leo and I loved your last series on becoming wealthy!

  9. Great post Erik. I think you’re approach is a sound one. I’d do the same thing. I really like how you fully funded 2016, and now you’re tackling your 2017 Roth. This will serve you well in the long-run. Nothing like tax free earnings!

    I’m not sure what the market is like where you live, but if it’s on the incline I suggest asking the lender for a new appraisal. Perhaps property values have appreciated to a point where your PMI will disappear. You’ll have to pay for the appraisal, typically between $400 and $600.

    Best of luck.

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      Hey Investment Hunting, I appreciate your compliment on my analysis. Once I finish up contributing to my Roth, then I’ll get into the taxable brokerage account dividend game! 🙂

      I’ve definitely thought about the appraisal. Properties in my area are on the rise, I’ll have to keep tabs on comparables in my area.

      Thanks for stopping by, you had a great Feb for dividends it seems!

  10. Excellent article. What you said is very clear and informative anyone can easily understand this. I think some of my friends want this type of article. It’s worth able to share it.

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      I appreciate your compliment and please do share! Our goal here at The Mastermind Within is to build a community of like minded individuals and allow knowledge to flow freely.

      Thanks for the comment Brian.

  11. Hi Erik,
    Congrats on making a plan based on solid data. I do find most of the pay debt vs invest decisions interesting as it doesn’t need to be one or the other – it can be both too. Nothing wrong with diversifying or having extra liquidity. Getting rid of the PMI is definitely a good though – I had it on my first mortgage too.

    Best wishes,
    -DL

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      Thanks for stopping by Dividend life. It should be a very interesting year. I’m excited to keep building wealth.

  12. This is a debate that I have all the time and also just wrote about. I agree that getting rid of PMI is probably the best idea. As for pay down debt or invest, I generally go with invest IF the interest rate on debt is very low. However, I’m probably going to go with a balanced approach to pay down some debt just to sleep better at night. I’m not sure if you wrote about it in a different post but why did you decide to contribute to a Roth 401k as opposed to traditional?

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      Hey Andrew, thanks for the comment. I haven’t wrote a post on roth vs. Trad. Frankly, I believe taxes will be higher in the future and my income will be higher in the future as well. I will want to reduce my taxable income in the future, so eventually I will switch to trad.

  13. Nice work great charts. I agree definally pay off that pmi. This is the big question I have been asking myself. I’m currently debating refinancing our mortgage to pull out some equity to invest for a higher return. But like seeing my mortgage go down. Million dollar question =)

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      I’m glad you agree PCI. I hope I’ve made the right decision, 25k in a year towards debt paydown is quite substantial!!

      It will be exciting.. thanks for stopping by 🙂

  14. It can be a really tough question to answer. Thanks for sharing all the details, Erik. I really appreciate the amount of thought and analysis you put into your decision. We reached a similar conclusion in regards to contributing the max to our IRAs while simultaneously paying down debt.

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