Why You Should Think Twice about Paying Off Debt!

by Krantcents · 49 comments

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Do you pay off debt or invest?  Many personal financial bloggers suggest to always pay off debt.  It is not that simple!  Whenever you have to make a financial or any kind of decision, you should examine all the alternatives.  It is commonly called opportunity costOpportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).

Background

A lot of college graduates begin their careers with a lot of student debt.  The average student debt is roughly $27,000 according to CNN Money.  The amount of debt varies depending on school, state and whether it was a public or private university.  The interest rates have remained low depending whether it was a subsidized or unsubsidized loans and a federal, state or private lender.  For example, undergraduate loans (Stafford) between 2011 and now are averaging 3.4%.

Private, unsubsidized loans may reach as high as 8.5%.  When you have a number of loans with different interest rates and principal, you can create an average loan rate by doing a weighted average.  If you have a $5,000 loan at 5% and a $10,000 at 6.8%, the weighted average is 6.25%.  You must look at the weighted average of your loans to determine your opportunity cost.  Do you pay off the loan or invest?

As you pay off your loan your net worth increases because you reduce your debt or liabilities.  As you pay off your loans early and make additional principal payments, you pay less interest.  The interest rate is based on the principal, interest rate and term of loan.  If you pay less interest, your Annual Percentage Rate (APR) will go down.  So what do you do with the extra money?  When you increase assets by investing, your net worth increases too.  What is your choice?

What Should You Do?

When you are making your loan payments and you have an extra $150 per month, should you pay down debt or invest in a (tax deferred retirement plan) 401K?  What factors should affect your decision?  Investing in a 401K is important and time is on your side!  The longer money remains in a 401K the more opportunity it has to grow.  Add an employer match; it is a lot to give up.  This is your alternative to paying off debt.  Giving up as little as five (5) to ten (10) years not investing is meaningful and will affect you balance significantly.  Can you do both?

Paying off debt or investing is not an either or choice.  Using my example above, your weighted average for your student loans is 6.25% and the average stock market return on investment is an annualized return of 8.5% over the last 112 years.  Remember, this is just an average and can be very different depending on when you enter or exit the market.  Let’s presume the return is similar, but your employer matches a portion of your contribution.  That would increase your return.  The most important factor is the amount of time your money has to grow.

Compound interest affects your balance!  The real growth in your balance occurs between the thirtieth (30th) and fortieth (40th) year. Using a simple example of contributing $150 a month for forty (40) years with an average return of 8.5%, you will accumulate $610,088.92.  By just cutting the investment period by ten (10) years, you will have only $249,359.73.  Cutting the investment period just five (5) years to thirty-five (35) years reduces the balance to $392,092.73.  As you can see, investing returns and time can materially affect your balance.  Can you do both?

A little bit of sacrifice can materially affect the outcome.  What can you do?  You should think about the expenses you can reduce to free up some funds to pay your loans and still contribute as little as $150 per month into a 401K.  Many people think, they will just increase the contribution later and it will make up the difference.  You have to increase your contribution to $375 per month for thirty (30) years in order to accumulate $623,399.33.   I think my illustration shows how time makes a big difference in the balance.

Final Thoughts

Should you pay off debt or invest?  I think you should do both. Make your loan payments, but find additional money to contribute to your 401K.  If you contribute as little as $150 per month to your 401K you can make a big difference.  You can find the money, if you bring your lunch to work or take in a roommate  to name just a few examples.  Either one will yield more than $150 per month.  For more ways to save money you may want to read 25 Money Saving Tips, I Use.   Presuming you are earning $40,000 a year, $150 per month is just 4.5% of your earnings.  Any employer match is a bonus.  What are you going to do?  You can pay off  debt and invest too!

Photo by: MSCSA

Carnivals:

Yakezie Carnival at Young And Thrifty
Y and T’s Weekend Ramblings at Young and Thrifty.ca
Carnival of Retirement at Making Sense of Cents
Carn. of Financial Camaraderie at My Personal Finance Journ
Carnival of MoneyPros at Family Money Values

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{ 44 comments }

My Financial Independence Journey April 4, 2013 at 2:31 am

This was a very insightful take on debt vs investing. The one kind of debt that I’m convinced should be paid off immediately is credit card debt. Even if it’s not much in the grand scheme of the weighted average, 25% interest rates on any amount of money should be avoided.

Krantcents April 4, 2013 at 6:51 am

I totally agree and even wrote an article regarding to be published soon.

Mrs. Pop @ Planting Our Pennies April 4, 2013 at 3:22 am

We try never to give up an employer match or Roth IRA opportunity, and then after those we look at paying down our debts. But then again, we’ve never had credit card debt so all of our debt has been at 7% or less.

Krantcents April 4, 2013 at 6:54 am

Good job! Investing is as important as reducing debt. Either way, you can increase your net worth.

Greg@ClubThrifty April 4, 2013 at 4:44 am

Like the PoP’s, we also never try to give up an employer match. Therefore, we are doing both. However, if you had to choose, I would still go with debt first. To me, it is a question of excitement and focus. Sure, mathematically it is probably incorrect. However, emotionally (and in a risk sense) it is the better way to go. It is hard to get excited about your $5,000 turning into $5,500 over a year. It is easy to get excited about paying down $5,000 worth of debt.

Krantcents April 4, 2013 at 6:55 am

It is a personal choice, however I wanted to point out how even 5 years has impact on the outcome.

maria@moneyprinciple April 4, 2013 at 4:52 am

Couldn’t agree more, Krant. I know we did work hard to pay off our consumer debt but this was different (though there was some emotion involved in all that). What I don’t understand is people getting totally focused on paying of their mortgage – this is likely to be one of the cheapest debt to service ever. Cleverly leveraged it can be very important investment tool!

Krantcents April 4, 2013 at 6:59 am

I agree! I think it is a question of opportunity cost. I invest the money elsewhere and earn more than 3-5%.

John S @ Frugal Rules April 4, 2013 at 5:28 am

I could not agree more. If your company offers a 401k match, then I say everyone should take advantage of it. It’s free money, which is nearly impossible to get…plus you get the time aspect and it makes complete sense to put money in the 401k. I would even go so far as to suggest that you find ways to cut your expenses so you can also put a little bit into a Roth each month.

Krantcents April 4, 2013 at 7:00 am

I do not even get a match! The time invested makes a huge difference over the long run.

Grayson @ Debt Roundup April 4, 2013 at 8:07 am

I went with the dual-pronged approach. I think it was important to pay down debt and invest. My percentages varied over time as I would spend 70% of my discretionary income on my debt payments and 30% on my investing, then I would switch to 50/50 then to 30/70 as I got closer to paying it off. This worked for me and allowed me to hit the ground running when I paid off my last card.

Krantcents April 4, 2013 at 11:14 am

Time is the biggest advantage of investing and just 5 years can be meaningful.

Lance @ Money Life and More April 4, 2013 at 8:18 am

I totally agree that you need to consider opportunity costs. Unfortunately most of my fiancees student loans are at 6.8% or higher so we are working on paying those off. We wont be paying our mortgages off early though as investments will provide a better return.

Krantcents April 4, 2013 at 11:15 am

As my example shows 5 years can be very meaningful for investing, it is a personal choice.

Jason April 4, 2013 at 9:39 am

Opportunity cost is a very important topic many people forget about. I think this comes up most often today with mortgage interests rates at the currently low levels. Do I pay off my 3.5% mortgage or invest, where risk-premium suggests I can outperform? It comes down to what you as an individual are willing to accept risk wise.

The piece of this article I disagree with you on is your comment that you must look at the weighted average of your loans. In your example, the individual has a $5,000 loan at 5% and a $10,000 at 6.8%. You choose 8.5% later to compare for investing. Let’s assume I’m already investing and getting all matches available, and I’ve already optimized my budget that I’m spending as little as I’m comfortable with, and I have the extra $150 you referenced available to me. The choice isn’t between investing at 8.5% (with risk) and paying off loans at 6.25% weighted (without risk), which gives me a 2.25% risk premium – it’s between putting the $150 into my 6.8% loan resulting in a risk premium of only 1.7%.

Honestly, at either level, I’d put the money into the loans because don’t forget they compound too! The 1.7%-2.25% isn’t enough to justify the risk to me, at least. However, when compared to the 3.5% on a mortgage, the 5% risk premium is completely worth it to me.

Krantcents April 4, 2013 at 12:56 pm

As my example shows by putting off investing for just 5 years, it make a dramatic difference in your balance. It is a personal choice, I don’t think it is a either or situation. You can do both.

Rob @FinancialSprout April 4, 2013 at 4:26 pm

It would be even more helpful if you were to start investing even before you got to college. I am hoping to have an IRA started by my 18th birthday, so I can get an early start on investing. would it be helpful to pay half of your extra money on the the principal of the loan, and invest the other half?

Krantcents April 4, 2013 at 5:25 pm

You’re right, however most people do not invest that early because they have other priorities! I helped my son and daughter invest when they were young 13-14 y.o.) They used the proceeds to buy their first cars.

Shaun @ Money Cactus April 5, 2013 at 2:34 am

You are right about the small amounts, compound interest can have a huge effect on even the smallest contributions over time. It’s nice to get that debt paid down too, so a balanced approach is good. Once things like college fees are paid for those payments can be snowballed into the mortgage or your 401K to really kick it along!

Krantcents April 5, 2013 at 6:55 am

Thanks, the earlier you start investing, the better. Even 5 years makes a difference!

Alan@escapingmydebt April 5, 2013 at 6:21 am

This is a great post. I would agree with you that finding a little extra to invest is very wise because of the opportunity costs. My wife and I currently contribute about half the max of what we could do into our 403b. The part that I do not think some people consider is the fact that say you currently contribute $200 to your retirement which is most likely a pre-tax, if you decide to stop that deduction to pay off your debt, one, you lose the ability to earn more. Two, you also will only see about $100 in your pay check. Granted it may help, but not as much as you think.

Krantcents April 5, 2013 at 6:57 am

Thanks, time is very important with investing. Investing early makes a big difference in the long run.

Tony@WeOnlyDoThisOnce April 5, 2013 at 7:12 am

This is something that everyone with student debt should read. Very sound reasoning – I’ll let people in this situation know!

Krantcents April 5, 2013 at 7:28 am

Thanks, just missing out on a few years of investing affects the balance significantly.

Holly@ClubThrifty April 5, 2013 at 7:51 am

I agree that you don’t have to do one or the other. You can do both at the same time! We try to do a little of everything, all at once =)

Krantcents April 5, 2013 at 9:20 am

In an effort to reduce debt, many people forget that investing is just as important. It is great you are doing both.

Jai Catalano April 5, 2013 at 8:09 am

I think you are right. You should pay off your debt and invest. It’s a balance and never an easy one. By the way there was a good editorial on older folks who take on roommates. My neighbor who also babysits for my kids once in a while does it as well.

Krantcents April 5, 2013 at 9:24 am

Thanks, roommates is an option although you give up privacy. Some day I may need a companion to take care of me. My LTC insurance will pay for some young Swedish girl to live with me. LOL!

Darwin's Money April 6, 2013 at 8:13 pm

Good example; if your employer offers say, a 50% match on the first 6% invested or whatever, invest 6% !! Where the heck are you going to get a 50% return anywhere else?

Krantcents April 6, 2013 at 9:28 pm

Thanks, even without a match 5 years can make a big difference.

Lauren @ Cheapstudents.ca April 7, 2013 at 7:29 am

This is definitely something I’m considering when it comes to my student loan debts. The interest rates aren’t extremely high and it may make the most sense to invest.

Krantcents April 7, 2013 at 8:10 am

Remember, I am suggesting to do both. Think about how you spend your money and use some of it to invest.

Untemplater April 7, 2013 at 10:30 pm

I didn’t really start investing until a few years after I started working. I worked on paying off my student loans and also spending money on clothes and such that I really didn’t need. Once I realized that I was throwing money away I started getting more interested in investing and getting out of debt fast.

Krantcents April 8, 2013 at 7:19 am

Good job! I think too many wait until their 30s or later to get serious about investing and that time is lost.

debtperception April 8, 2013 at 2:29 am

“Private, unsubsidized loans may reach as high as 8.5%” I just need to point out that they do go higher than this. I have two at 9.5% and 9.75% and I’ve even heard of people who have ones in the double digits.
Unless I can significantly increase my income, for now, I’ll stick to paying off my student loans because they are gaining about $15 in interest each day.

Krantcents April 8, 2013 at 7:22 am

As I suggested, you may want to look at your expenses. You can bring lunch to work or cut out other things to just invest as little as $50/100/150 per month.

AverageJoe April 8, 2013 at 6:44 am

It always frustrates me when I see someone lump sum money toward a debt that won’t be paid off in 25 years and is at 3%. You could have easily invested this extra and paid the debt more quickly!

Krantcents April 8, 2013 at 7:24 am

I agree, I think everyone who has student debt would just think about what they spend their money on they will find additional funds to invest.

Squirrelers April 8, 2013 at 8:43 pm

It’s tough to bypass a generous 401k match, debt or not. I say that while being one of those people that doesn’t like debt at all. Opportunity costs are important to consider in many aspects of life.

Krantcents April 9, 2013 at 7:12 am

Even without a match, you can see that 5 years can have an effect on your overall balance.

Bob Richards April 9, 2013 at 11:50 am

I love debt. As long as I can earn more on the borrowed funds than they cost, with a minimal amount of risk, I am a fool not to use borrowed funds. I have a 2.75% loan on my house, funds used to buy tax free bonds, all with yields above 5%. There are many circumstances like this in life.

Krantcents April 9, 2013 at 1:39 pm

Good, that was exactly one of my points! Eventually, you will pay off that house and have a lot of money tied up in that asset. It seems like you may want to access all those funds.

101 Centavos April 11, 2013 at 3:17 am

An employer match in the 401(k) should seem like a no-brainer. And yet it’s true: some people have no brains.

Krantcents April 11, 2013 at 6:57 am

Even without a match, just 5 years materially affects your balance.

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