Mailbag – should I invest or pay off debt?

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I received an email the other day that both I and the sender thought other’s may enjoy reading about. 



First the question:



So I have between 25k and 30k in student loan debt at 5.75% interest (I thought I was below 5 until I just double checked) on a very long payment plan (I’m paying like 250 a month).
About a year ago as an experiment I put $5600 into the stock market split between 3 ETFs.  In that year or so I have a total gain of 11.57% on that money.
With this said for future money I am saving per paycheck do you think it is better to try and aggressively pay off my student loan… or continue investing in the stock market since so far I seem to be earning almost double the interest rate on my loan?


My response:

What is the goal of this saving’s account and do you currently save for retirement? If this investment account is just for fun and wealth building and you’re already saving for retirement, I’d recommend that your focus shift to paying off the student loans. That’s right Personal Finance (PF) bloggers, I prioritize a portion of my retirement over debt reduction (depends on what debt and other factors). Before we get too ahead of ourselves, here, let’s determine our priorities (in order):
  1. Either make a budget or just flat-out find a way to pay all fixed and mission-critical variable expenses.
  2. Make paying yourself first a priority and save for emergencies and retirement.
  3. Pay down oppressive debt and debt with a ridiculous interest rate… aggressively.
  4. Find balance and live a reasonably priced life
  5. Identify the difference between good and bad debt and pay down reasonable debts (mortgage and the like) at a reasonable rate while continuing to invest additional funds for house, wealth, etc.

Maybe this list shocks you and maybe it makes sense. Either way, my justification is below:

It seems like you have #1 taken care of, as we’re discussing how to spend the extra cash you have coming in. #2 is where my questions start coming. Are you currently saving for retirement and, if so, by what means and with how much each month? At a minimum, you should be contributing whatever your company will match in a 401k, or at least a reasonable amount into an IRA if your employer doesn’t offer a retirement plan. 
Why is saving for retirement such a priority? You can’t replace the time when it comes to compounding interest. Here are two examples why. Stop me if you’ve heard these already. 

What would you rather have? 

A) $1 million right here and now, or B) a penny that doubles in value every day for 30 days (day 1=$0.01, day 2=$0.02, day 3=$0.04, and so on)?
If you delay the gratification and do the math, you’d see that B) gives you $10,737,418.2 after 30 days. That’s right – over ten million. After just 10 days, you’d be at $10.24 and wondering why you chose B. After 20 you’d be at $10,485 and feeling a little better but still a bit salty. After day 25 you’d be sitting at $335,544 and feeling pretty good about the next 5 days. 
So, to recap – day’s 1-25 earn you a grand total of $335,544 while days 26-30 net you $10,401,874.2. Liken this to saving for retirement and it illustrates the point that you cannot afford to wait, no matter how young you think you may be. A couple of years could cost you a fortune. 

Who has more at retirement age (we’ll go with 65 here)?

A) Someone who invests $100/month, each month from age 20-25 and then stops cold turkey, or B) Someone who invests $100/month, each month from age 26-65?
Assuming a constant 7% rate of return for both individuals, Investor B does come out ahead, but it’s by a much smaller margin that you may expect (the math is pretty rough but the estimate is close). Investor B would have just about $256,331 at age 65 and would have contributed a total of $48,000 toward his plan. Investor A would have contributed only $6,000 total and should end up with about $103,000 at age 65. 
Both of these examples are intended to illustrate that you cannot, under any circumstances, replace time. Bear that in mind when determining amounts for #’s 2 and 3 in our priority list above. Your 5.75% interest rate on that student loan isn’t phenomenal, but the highest percentage of interest accumulates at the onset and then fades away as your debt is paid down. Compounding interest that works in your favor has an exponentially opposite effect. 

Another question I’ll ask:

Let’s hypothetically say that you can pay down these student loans aggressively and it will take you 5 years to do so. We’ll also assume that during that time you will not invest any money toward your retirement (of course you’d be ignoring everything I wrote above and that would be sad). I’m going to give you 3 different scenarios that could be your reality after 5 years. You tell me which sounds best to you?
1) You’re at $0. Debt free but absolutely no money saved. Happy and terrifying at the same time.
2) You have about $10k left on the loans but you also have about $10k saved toward an emergency or toward your retirement. Your debt burden is reduced and falling but your wealth is also building.
3) You still have about $27k left to pay off and your sitting with about $25k in your retirement account. Sure, retirement is starting to look pretty rosy… Once you ever get there.

I’m going with the hybrid option #2. 

In my opinion, it’s the best blend between aggressively paying off debt while still keeping an eye on your future. It’s about a 2:1 ratio, debt:future that makes a good amount of sense to me. You’re using compounding toward your advantage and attacking loans at the same time. Win-win.

To address Archer’s situation, specifically:

Maybe we need to sit down and look at your financial situation in more depth but I want to know how much you can scrounge up each month. Also, is this investment account for fun, is it for an emergency, and are you saving for retirement in a different account? 
Let’s say you can come up with an extra $300 each month and that this fund is for your retirement. In that case, I’m throwing $200 extra toward the debt every month while investing the $100 in your retirement account. With $200 combined with the $250-ish payment you’re already making on your loans, you can expect to wipe them out in about 6 years or less. You’d also have the makings of a little nest egg, which you’d beef up as your income rose and debt fell.
If you’re already saving for retirement in a different account, I’d make sure that amount is respectable then throw all $300 of your extra onto debt. Estimated payoff timeframe: Just under 5 years. 
Want to get even crazier? IF you’re already saving for retirement in a different account and that amount is respectable, I’d take your $6,500 and throw $2k into an emergency fund and the rest at your debt. Total payoff time: About 4 years.


Thanks for reading!

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– Mike
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