When we first started our debt-free journey, this was the question I asked myself often. I also questioned the validity of delaying saving for retirement to make faster progress becoming debt-free. In the end, I reasoned that the mental freedom from being debt-free as fast as possible would be more beneficial over time as opposed to a much slower debt payoff AND investing strategy.
But numbers don’t always care about feelings. And this choice doesn’t necessarily mean it was the best financially.
As with everything in personal finance, it’s important to see the numbers in order to make a well-informed decision. Using simple investment calculators from Bankrate.com, the objective of this article is to walk you through a numbers-based approach that illustrates debt, investing, compound interest and the power of what I call “would-be” payments.
The core message? Whether you choose to delay your investments to pay down your debt or have a strategy that does both, you should avoid completely delaying both to live a luxurious lifestyle you can’t really afford.
Note: The numbers and variables are meant to serve as an example only. Of course, there are exceptions and more complexities. It’s the principle and the process of the exercise itself that matters.
Let’s say you’re 26 years old and currently investing $400/month into your 401(k). Good start. You decide that you want to retire at 60 because anything past that seems odd to you.
You’re also a college grad and a have balance of $25,000 in student loan debt at a 7% interest rate. If you’re curious, that would be about $5k less than the national student loan debt average in the US in 2019. Thus far, you’ve been making the minimum payment of $338/month but you’re finally starting to notice the minimum payment is not getting you very far. You ask yourself, is there a better solution?
Meanwhile, you’ve also been making some financial changes in your life and recognize you need to be smarter with your money. You manage to find a way – through a combination of smarter budgeting, job change/pay raise, a downgrade to your living situation and fancy car – to free up an extra $400/month out of your budget.
At this point, you might spit out your coffee and roll your eyes thinking that’s absurd. But is it really? Think about your situation critically. What are some ways you could free up money? Maybe it’s not $400 but any extra toward investment or debt will do. I didn’t say this would be easy.
Now, you have a total of $738/month to spend on just your debt, a combination of your debt and your 401(k), or re-upgrade your lifestyle. Which is better?
Let’s Run Some Numbers
Using your free Excel Loan Amortization template, your calculations show that you will be debt-free in by 34 (8 years) if you stick with your current plan of only paying the required $338/month minimum payment on your student loans. Forget about interest during this time for now.
Crunching further, you discover that you would be debt-free by 30 (4 years) if you use that extra $400/month you’ve freed up on top of the minimum debt payment. This would equate to a total of $738/month toward your debt. Not bad!
But you’ve heard that investing young should be your number one priority. “Compound interest is the 8th wonder of the world,” says Warren Buffett! But you can’t help but wonder, what makes more sense for me?
You have a couple of options here but the right option is the one that makes you take consistent action. Take a look at some numbers below to illustrate this principle conceptually.
The first option
First, let’s look at that extra $400/month invested in your 401(k) until your debt is paid off at age 34. Keep in mind that this assumes your situation will change at 34 so disregard beyond that for now.
This means that instead of using the extra $400 on top of your minimum debt payment, you start investing that money immediately. This would give you a total of 8 years of accumulation by the time your 34.
Assuming your initial investment of $0 and an average rate of return of 7% over those years, you would have gained about $50k in tax-advantaged money over this 8 year period.
You are now debt-free after this 8 year period as well. Because you’re financially savvy, your plan to apply the “would-be” $338/month minimum payment you’ve been making to your retirement instead of upping your lifestyle as many others do.
As you can see below, at 34, you’ll be starting at $50k which is the product of that past 8 years of 401(k) investment commitment. Since you’ve now bumped up the contribution to $738/month ($8,856/year), from age 34 to retirement at age 60 (26 years) you would end up with about $900k in your 401(k).
You might call this the “balanced” approach because it’s not overly aggressive in any which way. As you will see, it also nets you the most $$ over time.
The second option
Now let’s look at a scenario where you start investing at age 30 after aggressively becoming debt-free. You might call this the “Dave Ramsey” approach.
Under this scenario, since you have been paying the extra $400/month on top of your minimum payment, you would use the “would-be” $738/month ($8,856/year) you’ve been paying on your debt toward your 401(k) investment strategy.
Under this assumption, your accumulation time would be 30 years and starts at $0 since you’ve deferred your investments over the past 4 years.
Here, you can see the numbers are showing the power of the compound effect. Using the wait until your debt-free to invest strategy, you will have about $64k less by age 60.
That could be the epic RV you envision buying to travel around the US at 60! Maybe you should reconsider your strategy and choose the first option after all?
Just wait, you could do much worse. There’s a hidden third option that can really wreck you.
The third option (do not choose this one)
What if you never commit to your Financial Freedom, carry unnecessary debt and avoid investing? Be careful of this scenario.
Here, you continue to pay the minimum on your debt and never attempt to free up that $400 bucks a month because you refuse to delay gratification and set yourself up financially in the future. I’m talking about fancy car leases, the expensive oversized apartment you may not need, lots of clothes, shoes, booze, and other lifestyle creeps. No judgment of course.
But hey, we will cut you some slack. You’re somewhat financially savvy and realize you better get started investing. So at 34, when you’re finally done paying off your debt, you shift that “would be” $338/month to your 401(k) and start investing. That’s still young, right? Look how much living I did during that time you say?!?
But you forget about the other part of the financial formula. Instead of slowly building your investment contributions over time as you become more awesome, you determine that you’ll roll the dice with this measly $338/month until retirement.
Because living in the present is more important than the future, you never took the time to do the calculation and learn about smart money moves.
Compared to the previous two options, this solution leaves you with about $550k less in retirement. Or when you said you wanted to retire at age 60. That $64k RV purchase would be devastating to you and you may even need a few more years to officially “retire”.
While you are investing which is a great thing, the mindset of “good enough” and kicking it down the road until “someday” will leave you less financially sound in the future.
you have options
Maybe you do have it figured out with a variation of the third option and have intentionally figured what you need out. I would never judge you if its a well thought out approach that factors in all of the variables of your current and future lifestyle. But if you’re just throwing darts at a wall, I suggest you aim at a dartboard instead.
Just because my biggest financial goal in my 20s (and early 30’s) was to become debt-free doesn’t mean it should be yours too. Although I think you should reconsider if not. Beyond achieving this goal, I learned something more important throughout the process; to live within my means and find true meaning elsewhere without all of the fancy accessories, cars, and lifestyle creeps.
I am not suggesting that the super aggressive debt payoff is the only solution. The purpose of this article is to show three things:
- If you are choosing to aggressively become debt-free and delay investing, you won’t be that far behind the ball as long as you execute a plan to get back on track when you’re done.
- If your end goal is accumulating the most money in retirement then the split scenario that has you investing earlier probably makes more sense. But carrying your debt and not committing to your financial freedom over time is not a wise decision. Despite what the norm in the US is, it’s ridiculous to think this way.
- Not investing, living with debt, frivolous spending, a fancy lifestyle and delaying wise financial decisions will leave you broke over time.
Any which strategy you choose, challenge yourself to become a better person by evaluating your complete financial situation. What would your life look like without all of this stuff? What is your definition of Finacial Freedom?
The world needs you free from the shackles of debt to fulfill who you’re meant to be. Because if you are actively making financially smart decisions, you will become wealthy in more ways than one.