If you are in your 30s or 40s, does this describe your financial situation?
After years of working your way up the corporate ladder, endless long nights as an associate in your firm, or completing your residency or fellowship, your career is finally well established. New financial rewards are coming your way from a new job or promotion, hefty bonuses and other compensation that often didn’t seem possible.
For the first time, there is a flood of financial opportunities and you have the resources to consider them. You can buy your first house – or move into a larger one; take a European vacation or get a new car.
You may also be deciding between whether to aggressively pay down debt or save more money for retirement, but which strategy is the right choice?
Most people are naturally debt averse. No one likes a large credit card balance or the seemingly endless payments to cover student loans. But allowing our natural aversion to debt to control our decisions isn’t always optimal as part of a long-term financial plan.
Deciphering the best option is largely based on a few important factors. How to decide? Here is a process I recommend:
Make Certain Your Financial Foundation is Sound
First, understand what I like to call the financial order of operations. Think of this concept as a financial version of Maslow’s Hierarchy of Needs, which depicts people’s basic needs as a five-level pyramid with physical needs on the bottom and self-actualization on the top.
Before deciding whether to pay down debt or invest – items that are near the top of your financial pyramid – make sure your foundation is in order. Start by answering the following questions:
- Do you have an emergency fund in place? Having enough money to cover three to six months of expenses is recommended so you won’t need to borrow if the car breaks down or another emergency occurs.
- Are you paying the required balance on your debt obligations each month to not only avoid penalties but to reduce principal? If not, you need to begin doing so.
- Are you taking advantage of your employer match in your company retirement plan? Maximizing your company’s contribution may earn you a substantial amount of additional retirement savings over time.
If you haven’t checked all the items above, using excess funds to accelerate debt paydown or further invest in your retirement should take a backseat for now. Remember, you can’t construct a strong building on a weak foundation.
Pay Down Debt with High Interest Rates First
While the term “high” is purely subjective, a good rule to follow is to prioritize paying down debts with interest rates over 6%-8%. For example, a credit card with a 16% annual interest rate should be prioritized over maximizing your 401(k) contributions. However, debts with interest rates below the threshold above require a little comparative analysis to determine the optimal financial strategy.
Next, Should You Pay Down More Debt or Invest?
Compare the benefits of paying down debt versus investing excess cash.
For example, if you have $5,000 of additional income available, does it make sense to pay down student loan debt with a 9% annual interest rate or invest in a portfolio with an expected return of 6%? By investing all of the money, and not paying down debt, you would effectively have lost 3%, or $150, at year end. In this case, pay down the debt.
However, if there is a car loan with a 3% interest rate, the script is flipped – you would gain $150 from investing your excess income.
On the surface, this break-even equation seems like it provides the final solution to our question. However, using this logic in our decision-making may not create the most optimal strategy. One shortfall of the equation above is that it’s nearly impossible to predict investment performance. So, would it be prudent to base our financial decisions solely on mathematical equations that derive their solutions based on unpredictable assumptions? In simpler terms, shouldn’t we avoid making decisions based solely on unforeseeable outcomes?
Take Other Non-Financial Factors into Account
Most people don’t like taking unnecessary risks. You may be wondering: “Shouldn’t I always make the best financial decision regardless of my attitude toward risk since it will result in the best outcome?”
The answer: It depends. The best financial plan is one that you can stick with. If having student debt or a car loan keeps you from sleeping at night, it may be a better decision be to pay down those obligations rather than invest the excess money in your budget.
Or if you want to retire early at 50 and need to save as much as possible, it may make more sense to allocate more toward saving and less toward debt paydown to align more with your goals. We all have own preferences, attitudes, risk tolerance and goals. In effect, what matters most to you is often the right answer.
When determining whether to invest excess income or use it to accelerate debt paydown, consider talking to your financial adviser to come up with a gameplan that incorporates both the financial and non-financial factors this decision entails. This will allow you to achieve your goals while further enabling you to focus on what matters most.
