Should I Pay Off Debt or Invest?
Have ever wondered whether your dollars were best spent on paying off debt or investing? Are you just feeling overwhelmed with your student loans or credit card loans and wondered when the day would come where you’ll be debt-free? Not only that but have you ever questioned whether you should be investing as well? Have you had that fear of missing out on stock market opportunities while paying off debt? Well, today, we’re going to answer whether it makes more sense to pay off debt versus investing.
In this day and age, never has this question been more critical. When we look at the landscape surrounding this question, we have two considerable concerns that we’re trying to address. Household debt is at an all-time high, and it’s easy to understand why. Millennials coming out of college are facing an average of $50k in student loans. Just to put into context, student loans had hit an all-time high of $1.4 trillion in 2019. Student loans are now the second-highest level of debt in our country with only home mortgage preceding that category. $1.4 trillion...my goodness that is a scary number. To think that this is higher than outstanding credit card debt is mind-boggling.
Don’t let debt crush your dreams and goals.
On the other side of the spectrum, we’re facing a retirement crisis. Millions of Americans are questioning whether they can retire on time and not only that, be able to be financially secure through retirement. That’s a critical point there that I keep coming back to, it is not only important to reach retirement but we must see it as getting through retirement.
And it’s understandable why there are so much hesitancy and concern. The future of Social Security is questionable at best. For two years in a row now, the money flowing out of the Social Security Trust fund exceeds the amount of money flowing in. Remember, Social Security is designed to provide a government-sponsored pension based on taxpayer dollars. Those of us that are working and paying into Social Security are essentially paying for those that are retired. This has been going on since 1935. It’s a constant cycle of money going in and money coming out. But for the first time ever we’re seeing more money coming out than money coming in. What is that attributed to, you might ask? Well, it’s attributed to longevity. When Social Security was started 85 some-odd years ago, our country did not anticipate life expectancy going well into the 90s.
As our country faces a retirement pandemic, how does your retirement outlook seem like? Having a financial plan in place will at least take the blinders off.
So going back to the numbers, the Social Security Trust Fund publishes an annual report on the state of affairs, and it’s showing that exhaustion of the trust fund is expected in 2035. Fifteen years away is not that far from today. Now, it’s important to remember that Social Security doesn’t just disappear. It’s based on payroll, which in its current form, it’s anticipated to provide 79% of expected benefits. So with that said, the question now becomes what happens in 2035? If you’re retiring today and collecting 100% of benefits, does that mean in 15 years your Social Security amount is going to drop by 21%? No one has any answers to that, and reasonably speaking, I just don’t see how that would work. Imagine waking up January 1st, 2035, and getting only 79% of what you received last month for Social Security. What expenses will you cut? Is it food? Is it medical? Again, rationally it is impossible to make that adjustment when currently 45% of elderly Social Security beneficiaries consider those payments as 90% of their income.
90%!! It’s no wonder that so many of us are questioning whether we should pay off debt or invest. Cause clearly; we can’t rely on the system to take care of us financially when the system itself is broken.
Just FYI, I’m going to be releasing a deep dive into Social Security, the numbers, how it works, anticipated coverage, and overall strategies. If you’ve got more questions on Social Security, drop me a message, and I’ll be sure to address those questions.
The answer to our topic’s question isn’t so clear-cut, and what I mean by that is we ought to take this approach of maximizing our dollars first. If you’re sitting there debating whether to pay off debt or invest, then I strongly urge you to come out with a few factors. What I recommend is first assessing whether your debt is considered good debt or bad debt. Bad debt is straightforward: their high-interest credit card balances, high-interest personal loans, unpaid medical bills, things of that nature.
Good debt is your mortgages and your student loans. I call them a good debt because they were used for a purpose (buying a house and furthering our education), and those debts were used to provide internal equity. Having a paid-off home means we’re not forever throwing money down the rent drain. Renting is like paying for someone else’s home… you have no equity. Twenty years, thirty years, forty years, it’ll never go away. Homes have a finite period of financing...in 15, 20, or 30 years you know that home will be paid off, and your only obligation to housing after that is insurance and property taxes.
I also consider student loans a good debt because, for the most part, it is necessary to get a better job.
After you have assessed your debt, you want to determine if you have a 401(k) retirement plan at your place of employment and, more importantly, if that plan offers a match. It’s important to know that not all retirement plans do.
So with all that info here in front of us, I always recommend at least putting enough into your 401k to get that match money. I recommend this because time is of the essence, and not doing so means you’re leaving free money on the table. I work with a lot of 401k plans, and time and time again, when I talk about benefits, I ask if there is anyone who is not currently enrolled in the 401k that wish they did when they started. It never fails… and listen, I get it. It’s a new job; you’re not entirely confident if you’ll be there a year from now or you’re not sure if you can make ends meet. Well, I’m here to tell you that you can probably set aside $20 every two weeks if you want to. Or whatever that number may be, if it’s $30 or $40 or $50. You will realize that if you set it and forget it, you will automatically adjust to, however, less goes into your bank account.
Because the truth of the matter is, the majority of us don’t look at the withholdings on our paychecks. In all of my financial wellness courses, individuals predominantly just checked their bank accounts on payday Friday to see what was deposited, and they know that’s how much they can spend before the next paycheck. So, systematically setting up contributions to your 401k so that it is out of sight and out of mind is no brainer. I once met with an HR admin who, at his job, conducts payroll, why he didn’t contribute to his 401k, and he answered that he wasn’t sure he was going to be at the company long enough to see an impact on his financial wellbeing. Well, five years later, he was still there and had received multiple promotions and raises. To say he was kicking himself in hindsight is calling is easy. And how many of you are in that position? Perhaps you didn’t think you would be working there long? Or you didn’t think it mattered? Well, it does matter because every dollar you put in, if it is pre-tax, will save you on taxes. If your plan offers a match, you are getting free money. Even if the stock market were FLAT for the last five years, the HR admin would have made money because of the match.
Never forget to take advantage of free match money from your employer. Your future self will thank you for it.
I know it goes against certain individual’s recommendations like Dave Ramsey when he says not to contribute to a 401k until the debt is paid off but reasonably speaking, we are not in the same ballgame anymore. I’m a big fan of his book Total Money Makeover and the philosophies he preached about back in the early 2000s but here now in 2020 there are certain aspects that are not as viable and delaying retirement contributions until all debt is paid off is one of them.
So again, if your company offers a 401k with a match. Put in the money to get the match. That match money is essentially a 100% return on your money. Five years from now, you’re going to thank yourself and your boss. Believe me on that one. However; If your company does not offer a match then just skip that step and go right onto the next one…
Which is paying off credit card debt. Credit card debt is the evil that all evils are afraid of. Even the devil is afraid of 28% interest rates! When you’re facing high-interest credit card debt the only way to knock it out is to aggressively pay it off. If your credit score is good (typically around 720 and above) and you have a sustainable income, I would recommend you utilize a 0% credit card to lessen the severity of interest being charged.
Maximize your spending by capitalizing on points and cash-back via credit cards but let not the balance linger due to highest interest rates.
Some of the best debt consolidation credit cards that I recommend are the Discover It and the Chase Slate. Both of those generally provide 15-18 months of 0% interest. There is a caveat; this is recommended if you believe that you are capable of having that debt paid off in the 15 to 18-month timeframe. Knowing this is critical because those promotional offers only forego the interest if the balance is paid in full during that time frame. If you go over the 15-18 months, the interest that would have been accrued will be tacked on. You do not want that to happen!
If you are facing an exorbitantly high amount of credit card debt and don’t believe it possible to pay it all off within the 15 to 18 months, then transfer the amount that you reasonably can, pay that off during the time frame and repeat the process. When you follow this step, you will find that 15 to 18 months will fly by, and you’re quickly on the road to financial freedom.
With high-interest credit card debt knocked out, you ought to move on to tackling student loans if you have any. I always recommend prioritizing student loans over auto loans or car loans for two reasons. Auto loans are generally low interest because it is collateralized. In today’s rate environment, it is not out of the ordinary to have auto loan rates at 4%. Auto loans also are finite loans; they have a precise term like sixty months. Most of the people I work with also carry less auto loan debt than they do student debt. Vehicles are also depreciating assets, so for all these reasons, I prefer carrying the debt and having it paid off on the scheduled time as opposed to a student loan, which could last for the remainder of your life.
When it comes to student loans, you probably see interest rates in the range of six to eight percent if you have it through the Federal government. For student loans from private banks, you’ll probably also be seeing rates in that range if not higher. Those are the worst ones to carry, so you want to focus on paying those off quickly and early. Privatized student loans from banks don’t have forgiveness or forbearance, so it’s not the best one to carry for the long-term.
With student loans now sitting as the second highest form of debt behind home mortgages, it’s no wonder that our younger generation is stressed financially.
Federal student loans come in two flavors: subsidized and unsubsidized. The subsidized ones are the best ones to have because the interest does not accrue until after graduation. The unsubsidized loans are the ones that start accumulating from the moment you take receipt of the loan. When it comes to paying off a debt, you want to put yourself in the habit of rolling all payments forward.
What I mean by is this: when you’re first starting on this program, you’re probably stretched pretty thin. You’re making minimum payments to all of your student loans, the minimum to your auto loan, and as much as you can to your high-interest credit cards. If you’ve been following the steps I talked about earlier and have hammered down your credit card debt down to zero; you’re going to want to take that payment you previously were making towards credit cards and directly combine it with your student loan payments so that you’re now applying a massive amount to that debt.
One keynote: if you’re that type who has been adding an extra ten bucks to this loan and an additional 100 to that loan, just stop that right now! Focus on one loan at a time. Instead of trying to spread your funds amongst many different loans, you’re going to go minimum on everything EXCEPT that which you are immediately focusing on destroying. Once that loan gets destroyed, you’re going to then move onto the next one and focus on that. Every extra dollar goes to the one you’re focusing on, does that make sense?
So, for instance, if you were previously making $500 monthly payments to the credit card debt and you completely CRUSHED it in that 18-month timeframe, you’ll want to continue that momentum by applying that $500 to the next loan. Let’s say you’re now focusing on 1 of 4 student loans. I say this because most of you have different loans based on the semester or quarter you took them. Pick the one with the lowest amount (FYI, did you know that you can specifically direct your payments? This is an important point, and I’m going to go in-depth on this after this) So you pick the one with the lowest outstanding debt and let’s say you were applying twenty bucks a month to that loan… well, now that you freed up $500 from the CRUSHED credit cards, you’re now able to use $520 to that one student loan.
Do you see how much faster you could be paying off that loan as opposed to trying to stretch your payments here and there? You need to steamroll your payments when it comes to paying off debt.
When it comes to student loans, you need to give specific instructions to your student loan provider about extra payments because if you do not, any additional payments just go towards the interest being accrued. Student loan interest accrues daily, so if you’re making additional payments mid-month, the provider will take that payment and apply it towards the accrued interest rather than putting it to the principal.
Additionally, if you do not designate where additional payments are going, they will most likely just divide it between all your loans. You don’t want that! What you want is to designate a specific student loan out of all that you have and aggressively pay towards that with the additional STEAMROLL funds that you now have from paying off your credit cards. And you keep doing this after you pay off an individual student loan. You continue steamrolling your payments towards the next one.
I like picking the ones with the lowest principal balance because I just love seeing debt get annihilated, you know what I mean? Some people will suggest targeting the debt with the higher interest rate because that’s accruing at a higher rate, but personally, for me, it doesn’t matter so much as the lower balance. That lower balance debt can get annihilated faster than a higher balance with a lower rate, and annihilated loans can’t accrue interest.
At this point, I want to pause and talk about student loan refinancing. Modern-day lenders are extremely competitive and flexible as opposed to traditional bank refinancing. I’m talking about lenders like Sofi, Earnest, and Laurel Road just to name a few. Typically, you’ll find low-interest rates from these guys compared to traditional banks. More importantly, they offer LOWER rates than Fed loans. Just to give you an example, we’re now seeing 2% variable rates to an average of 4-5% fixed rates for those with good credit scores. Even when it comes to the fixed rates, you can save on average of 2 to 3% on your student loans and that’s a big deal!
Banks like Sofi, Earnest, and Laurel Road are highly recommended especially if you carry private loans from traditional banks. Moreover, these companies provide additional benefits like pausing your payments if you become laid off.
Now, I often get asked if a person should refinance the entire portion of their student loans over to someone like Sofi and Earnest. The answer is that it depends. With the Fed loans, you have a much higher threshold of payment flexibility so you may not necessarily want to refinance the entire portion. Now, if you’re dead set on having the loans paid off in a specific time frame like 5 years or 10 years and you have job security then, by all means, refinance it completely and save yourself on the interest.
Check multiple lenders to compare rates and decide if a student loan refinance is in your best interest. The one’s that I’m listing here have received great reviews from clients and friends who have undergone the process.
Believe me when I tell you that student loans can be knocked out. These big numbers are scary but you can do it if you commit to it. A few years back I worked with a dentist who had steamrolled his student loans. When he graduated dental school, he had accumulated close to a quarter-million in student debt. He knew he wanted to be completely debt-free and was willing to do whatever it took to get there. So when he graduated and secured a job, he did what many millions of Americans could not do. He maintained his expenses exactly the same as if he were still in school and unemployed. He did not immediately move into a fancy downtown apartment. He did not sign up for a new BMW and he did not splurge on fancy dinners. He kept living on in his tiny apartment, he kept driving the same car that was PAID OFF, and he kept on cooking his meals. He lived a minimal lifestyle and threw every single frickin penny at the student loans. And it worked! He came out of school making $125,000 a year and was able to successfully pay off a quarter mill of student debt in under 3 years.
Achieving financial freedom may seem elusive but it is really just driven by having a sound financial plan and determination to follow the necessary steps.
Now, your situation is going to be unique because that’s who you are. You may not have as much debt or you may have more. You may have a lower income or you may have a higher. What is very important at this point is to envision what those payments will look like and you have to do this very early on and you have to envision yourself steamrolling through the mountain of debt you have. Remember guys, this is not short-term, this is the long-game. When I run financial plans for a lot of individuals who are dealing with a debt crisis, our plan involves staying committed to making payments and these plans can be 4, 5 years or maybe even longer. But what you knock out in debt today will make your future plan much easier to manage. I promise you that.
If you’ve come this far and you have steamrolled your debt-whether it is the credit cards or the student loans, take this moment to stop and just pat your back on the shoulder. Go out and TELL somebody. No, seriously. This is one hell of an accomplishment and you need to let the world know that you broke the cycle of being burdened by debt.
Hopefully, at this junction, you are faced with a less difficult dilemma. Whether you should be investing or paying off your mortgage. Up until this point, you should have at least been contributing to the amount needed to maximize the match from your company 401k if there is one. If there isn’t a match and you stuck to my recommendation, you have not focused on saving for your retirement yet. Well, now is the time to start or kick it up a notch if you have already been saving.
The general consensus regarding how much you need to be saving for retirement currently puts that amount at 10% of your income. 10% of your income should be going towards your 401(k) each and every year. If you add the employer-sponsored match and most companies have a match in the 3-5 percent range you should effectively be seeing close to 13 to 15% contributions each year towards your retirement. But at this point, if you have successfully paid off all debt aside from your home, I urge you to hit the annual IRS maximum amount if you can. Currently, the annual maximum sits at $19,500 for those under age 50 and an additional $6,000 for those over age 50. If you have the means to hit that annual maximum, that is what you should strive for.
The power of compound returns if what starts your path to financial freedom.
If you’re able to hit the annual 401k maximum, your next step is to max out the Roth IRA if you have not already. The Roth IRA is a powerful wealth-building tool that will allow you to have tax-free withdrawals. The annual IRS limit is $6000 annually for those under age 50 and an additional $1000 if you’re over the age of 50 as a catch-up provision.
Even if you can’t hit the annual IRS maximum, but you’re sitting comfortably at the 10% contribution range, you’re still well ahead of the curve than most investors. I’m also going to follow up and say that it would be in your best interest to use the auto-escalate feature on most 401k plans, which will automatically increase your contributions by 1% each year. This way, it is out of sight and out of mind.
I often get a lot of questions on how to position a Roth IRA in conjunction with a 401k and what’s the best strategy for investing in those different accounts. I’ll be dropping a separate episode for that topic, so keep an eye out for that.
Maximize your retirement savings via vehicles like the 401(k), Roth IRA, and Traditional IRA.
So again, at this point, you’re probably sitting with just your home mortgage as the final outstanding debt, and you’re wondering if it makes more sense to max out your investment accounts or pay that off that house. What you need to consider are a few factors:
What’s your tax rate? If you’re in the high 30’s range, your best bang for the buck is maximizing your tax-deferred accounts because every dollar deposited is saved from high taxes.
Is the house you’re in the dream home or your forever home? If it isn’t, I would prioritize saving versus paying it off.
The last consideration is, what’s your age? This coincides with the previous question because if you’re young, you’re probably going to be moving around quite a bit, and not only that, you have many years to let your investments grow. Compounding growth is the most critical aspect that works advantageously for younger investors. If you’re older and closer to retirement, I’d say age 50 and above, then the priority shifts to paying off the house. This shift is because housing is generally the highest form of expense in retirement. If you can eliminate that or coincide with it, so home mortgage payments are removed by the time you retire, you’re in a much better position to be financially independent.
Remember, the longer you have until you need to touch your investments means the longer that account has for compound growth. I would always prioritize investing in a liquid investment account rather than an illiquid investment like a home. For the house, I’m not going to realize that gain until I decide to sell it, whereas the former provides me with more flexibility.
If you have finally hit the point where you are in the position of putting more towards your financial plan, I would then recommend putting excess funds towards paying down the house.