Should You Invest or Pay Off Debt?
Recently, I wrote a piece titled, “College vs. Retirement”. After posting it on LinkedIn, one of my connections asked about my thoughts on saving versus paying off debt. I told her I would write something about the subject just with her in mind. So here it goes!
The Simple Way
Most of the articles you see written about this subject are based on a simplistic idea. If the interest rate on your debt is higher than the return you can make on your investments, then you should pay off the debt first, then start to invest after that. This makes sense. Why pay 12% -25% on credit card interest when you can only earn %5 – 8% on a long term investment? If you’re talking about things like savings accounts and money market accounts, this argument gains more ground. When your savings account is earning .25% and your credit card is charging 12%, it’s a no brainer, right? Just pay off your high interest debt using the snowball method or the highest interest method, then you can start investing. Duh!!
Not So Fast There, Buckaroo!
Sometimes life gets in the way of math. It’s super frustrating and annoying. You have your awesome debt reduction, snowball, high interest first, attack strategy working to perfection. With your Excel spreadsheet in hand, you will not only have your high interest stuff paid off, you will have all of your debt paid off in seven years and then you will take the money you were paying towards the debt and start investing into your low cost, passive index funds that everybody talks about on the internet. In fact, I’m going to sell my new car, shop only at Costco, cut my cable, stop going to Starbucks, drop the gym membership and use those savings to accelerate my debt reduction time frame. I am on FIRE (Financial Independence, Retire Early)!
Then life gets in the way and screws everything up. The car breaks. You take the dog to the vet and it’s either pay $1000.00 or the dog dies. Your kid needs braces. Your 15 year old son gets his driver’s license and the car insurance doubles in cost. On and on and on and on………
What’s a Poor Boy To Do?
That’s a line from a Loverboy song titled, “Take Me To The Top”. It doesn’t really have anything to do with this article, but I remembered the line. You can listen to the song here:
Anyway, back to our story. How do you answer the question, should you pay off your debt before you invest? Here’s a plan that will probably work in more situations than not.
1. You Need A Budget
If you don’t know where you’re going, you’re probably not going to get there. If you don’t know where your money is going, it will probably end up being the same outcome. Some people look at a budget like a restriction or a diet. I have found having a budget and using it has given me freedom and control. As you probably know, we have been using a budgeting program called YNAB. I wrote an article about it here:
The budget allows us to give every dollar a job. We have embraced our true expenses. We are able to roll with the punches and finally, we have been able to age our money. I think having a budget and sticking to it is the first part of my plan to answer our question.
2. Emergency Fund
There are a LOT of articles talking about people not being able to handle a $500.00 emergency. When that happens, what do they do? Put it on the credit card, of course. Whenever you get in this financial planning death spiral, it is really hard to get out. Everything you read says you should have 3 to 6 months of your monthly expenses saved up in an emergency fund. This all sounds well and good until you start thinking about how much three to six months of your expenses add up to and how long it is going to take to accumulate that amount of money.
Here’s a little math. If your monthly expenses are $5000.00 per month, you are going to need $15,000 to $30,000 put away in an emergency fund. If you were able to put $500.00 per month into a savings account, it is going to take you 2.5 – 5 years to build up your emergency fund. That’s a long time. Plus it is sort of demoralizing. What about saving for retirement? My kids need a college education! Our car is old and my wife wants new furniture. Back to the Loverboy song!
Calm down big fella. Start small. Set a goal of having $1000.00 in your savings account. In our example, that might take, 2 or 3 months. Obviously, $1000.00 isn’t 3 months of expenses, but it will cover a lot of unexpected events that pop up. You go to Discount Tire and the dude comes out with that little tire measuring tool and then tells you the tires are really bad and you should replace them. You have your semi annual dental cleaning and you have a cavity. The dog barfs so you take her to the vet. Etc., Etc., Etc.
3. Get Some Insurance
You are required to have car insurance and homeowner’s insurance. I’m going to talk about life, disability and health insurance. Here is my order of insurance. First, you have to get adequate health insurance. Most people get this through work. If you’re in the Y.O.Y.O. Economy, you will have to get this on your own. Either way, YOU MUST, have at least decent health insurance. When I broke my leg, the gross hospital and doctors’ bills were over $100,000. That’s right. A little, after work, 45 minute bike ride ended up costing 100k! Frankly, my health insurance kind of sucks. We had a high deductible and our out of pocket maximum was almost $8000.00. Although I was not a math major in college, I know, $8000.00 is less than $100,000.00! If you don’t have adequate health insurance, one little accident or health scare can wipe you out.
Next up, disability insurance. I find that most people will buy life insurance before they look at disability insurance. This is the wrong order. 1 in 8 people will become disabled prior to the age of 65. I’m freaking Superman and it happened to me. If it happened to me, it could happen to you. After you have your health insurance, make sure you have disability or paycheck insurance. Your ability to earn an income is your most valuable asset and that asset needs to be insured. I’ve said this before, but if you had a money machine out in the backyard kicking out whatever, $60,000 per year, $100,000 per year, $500,000 per year, you would have the damn thing insured for its full value. You are the Money Machine! Make sure your machine is insured.
Finally, life insurance. If you love somebody or owe somebody money, you should have life insurance. If you want something easy, just buy 10 times your annual income in term life insurance. If you get some through work, subtract that amount and buy the difference on your own. Sometimes bad things happen and if you haven’t taken care of this beforehand, it’s too late. These days, term life insurance is inexpensive and easy to get. It just doesn’t make sense not to have life insurance.
The Big Reveal
You have your budget going. You have your first attempt at an emergency fund. You have health insurance, your ability to earn an income covered and you finally got the life insurance. Now what do we do? Do I pay off the debt or invest?
If you have a 401k plan or a Simple IRA or some other retirement plan through your job, I would suggest you should invest up to the company match before you start attacking the debt. Most 401k plans have a match that works something like this. If you invest 6%, the company will match the first 3% of your contribution. Even a Simple IRA matches dollar for dollar of the first 3% you contribute. Either way, it’s free money. Free money is good.
After you are getting the maximum match, then it’s time to start working on the debt. You can do the snowball method. You can list the debts in order and attack the one with the highest interest rate first. Mathematically it is best to pay down the debt with the highest interest rate. Emotionally, it might be best to attack the smallest balance first then snowball to the next one. Either one will work. I can write another article about that.
Life is rarely black or white. Either/Or. One Way or the Other. Pay off debt or invest. It’s about planning and flexibility and being prepared. I think this framework of budget, emergency fund, insurance, maximum match then paying off the debt works for a lot of situations. Every situation is different, of course, and as always, I would be happy to talk to you and figure out what is best for your own situation. I hope this has been helpful. As always, thanks for reading. KB