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 cost. Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).
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.
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
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
You can pay off debt and invest too!