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Invest or Pay Off Debt: Which option is best for you?

To invest or not to invest is a question many ask when working to get out of debt.  If you invest while getting out of debt it will likely take longer to become debt-free.  On the other hand, if you use the money you’d be investing to pay off debt you could be losing out on years, or even decades, of compound interest that could really add up when you retire.  As you can see, there are tradeoffs to either approach, so which is best for you?  Read on to find out.

There is no question that if you want to build wealth you most likely will need to invest, but the question is when to start investing, and how much to invest.  You could also argue another question is what to invest in.  These are all great questions to be thinking about as you work to become debt-free, and we’ll tackle the last two questions in a future blog post.  Let’s just focus on the question of when to start investing.

Debt first, then invest – pros and cons.

Many financial experts will tell you having focus is what powers your journey to become debt-free.  If you’re focused on too many things (i.e. retirement, debt payoff, kid’s college, etc.) you really aren’t focused, and it’s likely to take longer to get out of debt.  Think about managing your finances like a juggling act.  Juggling one financial ball (debt payoff) is far easier than juggling many balls (retirement, kid’s college savings) at the same time.  We can see the truth in this as having many balls in the air can also have a negative psychological effect by adding to the stress in your life.

The counter argument to this is that most people have the ability to setup retirement and college savings plans to be automated so you can just “set-it-and-forget-it” once you’ve put it in place.  You have to juggle a few financial balls to start with, but once they’re set you can then put all your focus on paying down your debt. 

Another argument for paying off debt first is that your return on that investment is guaranteed.  For example, if you have student loans at 5.5%, paying them off is a guaranteed return on your money.  You are guaranteed to save 5.5% interest the faster you pay them off. 

The counter argument to invest would suggest you will come out ahead by investing at a higher rate of return.  For example, if you took the extra money you have to pay down debt at 5.5% and instead invested it in a mutual fund earning 10% you’d come out ahead by 4.5% (10% investment - 5.5% interest = 4.5% benefit).  The problem with this argument is the 10% return is not guaranteed and includes risk, which is hard to put into the simple math comparing the investment return versus the interest payment.

Is all this starting to get a bit complicated?  If you’re like most doc’s who already have enough complexity in their lives and are not looking for more we might suggest the best approach for you is to stick with putting all your available income toward paying down your debt, and then turn your focus toward investments.

Debt pay down and invest at same time – pros and cons.

Investing while you’re in debt might be a better option for you if you’re willing to take on a little risk and complexity to get started.  Perhaps the biggest argument to invest while paying off debt is to get your company’s match, which is essentially a guaranteed 100% return on your investment.

The negative is that you have now prolonged your time to getting out of debt by investing and have to decide if that is more important to you than getting your company match.  If you get no company match or are self-employed we would suggest getting out of debt may be a better option, especially if you’re self-employed and can put away a lot of money in a few years when you’re debt-free, making up for the lost years spent paying off debt.

The decision is not as simple as reading a short blog post on the topic.  We suggest you and your spouse consider all the benefits of each approach.  What does your heart tell you is best for you?  Would you feel better knowing you’re debt-free or does losing out on a few years of investing worry you more?  There really is not a right or wrong answer as long as you begin investing at some point in the near future.

Doing the math.

Let’s look at what the math says about each of the options.  For the purposes of this example we’re going to assume $200K of debt at 5.5% on a 10 year repayment plan that begins the first year as an attending physician.  This would be typical of a graduating resident who has just refinanced their student loans, which average around $200K for most doctors. 

We’ll also assume a company match of 3% on a salary of $250K, which equates to $7,500 per year, and a 10% market return for any investment made.

So to summarize, a doctor making $250K per year could either take the $7,500 and put it toward their debt (technically it would be $7,500 minus taxes, but for our example we’ll keep it simple and leave taxes out of the math) or they could invest it and get the company match as well as the 10% market return.

From a purely math perspective what we want to calculate is the difference between interest saved (payoff debt option) versus the additional investment return reaped at the time of retirement. 

We’ll also assume the doctor in our example is 35 years old and will retire at 65 so she has 30 years to compound interest if she chooses the get match option.

Here come a whole bunch of numbers so work though this slowly to get a full understanding of the math.  If this quickly becomes too much for you, we’d suggest you need to seriously consider the payoff debt option and focus on investing once you’re debt-free.  If you can work through what follows and don’t feel too overwhelmed then perhaps you’re a candidate to do some investing while you get out of debt.

One option we absolutely don’t recommend is just making the minimum payments, but if you were to take that route you’d make 120 payments of $3,256 and pay $90,686 in interest – ugh!

A far better option would be to see how much quicker you could be debt-free by taking the $7,500 you could invest each year and instead apply it to your debt each month.  This would equate to around an additional $625 each month toward your debt.

The extra $625 each month paid on the debt would reduce the time to pay off the debt from 120 months to 96 months, reducing time to become debt-free by two years and saving $19,457 in interest.

The second option would be to take the $625 and invest it in the market each month along with the matching $625 from your company for a total monthly investment of $1,250.  In this example the additional investment would only apply to the 96 months from the aforementioned option, assuming once all debt was paid off the investment would begin anyway.  So how much would $1,250 invested at 10% for 96 months be worth?  $171,538.

Comparing the two options:

Paying off the debt in 96 months saves $19,457

Making payments for 120 months requires an additional $19,457 paid in interest, but the investment returns $171,538 for a net gain of $152,081.

The math clearly suggests investing (assuming a 10% average return) is a better option from a dollars perspective.  You might even suggest it becomes an even wiser decision when you calculate what the investment would grow to over 30 years.

How much additional money would one have if they invested $1,250 per month for 96 months and then let it grow another 22 years?  This calculation would effectively determine what impact investing while paying off debt might have at time of retirement. 

You would have an additional $1,396,366 at time of retirement taking the pay off and invest option!

Final thoughts.

Doing the math it seems silly to not pay off and invest at the same time, but keep in mind the numbers presented assume a constant 10% rate of return, which is realistic over many decades, but not year-to-year.  We also assume all other money beyond the $625 each month available would not be used for paying off debt, which is not likely to be the case if you’re really aggressive in getting after your debt.

What is more likely, assuming you’re serious about becoming a debt-free millionaire doctor, is that you would trim your budget to live like a resident and put most of your extra dollars toward paying off all debt in less than five years, and if you did want to invest stick to the minimum to get your company match. 

Check out our free debt shovel tool to see how much extra money you have each month once you have your basic needs covered.  Once you calculate how much extra you have you can then do the math to determine how big an impact focusing on paying off debt will have versus investing some to get a match that can lead to extra dollars at time of retirement. 

Ultimately, if you follow our advice by working to become debt-free and never get back into debt neither option will be a bad one.  Both will lead to having millions at time of retirement, leaving perhaps the most challenging question of all – how much is enough?



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