This past week a client asked me this very question. It’s actually a conundrum that many people face and wonder if they should be tackling all of their debt at one time versus saving and investing. As you can imagine, it really depends on personal circumstance and the amount of debt you have. First of all, it depends on the type of debt. Second, it depends on how much you are saving for retirement or other goals. Let’s take a look at what to do.
Keep in mind that debt comes in different types. You have some consumer debt that is high-interest and revolving and should be tackled and eliminated right away. Think about debt like credit cards where the interest is usually calculated on your daily balance and the interest can accrue faster than what you are paying each month. Quick reminder, credit cards should be paid off monthly as a goal. You do not need to carry a 30% balance of your available credit to build your FICO. That’s a myth! It’s best to pay off each month if you can. If you do have high-interest, revolving debt and are having trouble getting out of debt, we should do a debt analysis and consider whether you should use the avalanche, or snowball method, to pay it off.
Other debt is amortized such as fixed-rate mortgages and federal student loans. With this type of debt, if you can pay extra because you want to pay it off sooner, and you have met your savings goal, that’s great. Keep in mind that this type of scheduled debt is the most flexible for you to work with. If you do have extra over and above saving for retirement and other goals, go ahead and make that extra payment if it makes you feel good. However, generally speaking it’s best to invest any extra cash you have each month versus making extra debt payments.
The reason it is best to invest versus spending all of your extra cash flow on debt, is time. Time is probably the greatest asset you have when it comes to growing your wealth. Time is the one factor in saving and investing that you can never recover. The longer your invested money has to grow, the better. This compounding is a miracle that you cannot recover. Many folks think they will make up for saving as they age and earn more. This is a somewhat naive approach to take. If you are young and have very little left each month, it’s still better to invest that extra small amount versus applying it to a say a fixed-rate mortgage or federal student loan.
Let’s look at an old example I worked out. Nate, Ashley, and Sohn are all concerned about having some cash in the future. They each have a different approach as to how to save. The one thing that is constant is that they know they can each earn 8% on their contributions until age 65. Nate is working during high school and wants to save $5,000 per year, every year, starting at age 15 and making his last contribution at age 21. Nate doesn’t think he’ll need to save after that.
Ashley thinks she has the better approach. Ashley wants to save $5,000 per year starting in college at age 21 and save $5,000 per year, every year, until age 30. At that point, she thinks she can stop and not save any money after that.
Sohn wants to enjoy life and doesn’t want to even start saving until age 30 when he hopes to have a good job and better salary. Sohn plans to save $5,000 per year starting at age 30 and save that amount every year through age 65. Sohn feels this will be the best way to approach saving for the future.
So, who has the most at age 65? Nate only put away a total of $35,000 of his own money. Ashley did better and put away a tidy sum of $50,000. Sohn managed to sock away a whopping $180,000 by age 65. Have you figured out who has the most at age 65? It’s Nate.
Yes, Nate. Even though Nate only put away $35,000, with the miracle of compound interest his total contributions had more time to grow at our hypothetical 8% rate. This is the miracle of compound interest and the time value of money. Nate ended up with just over $1,424,000 at age 65. Ashley and Sohn did alright as well, but they didn’t earn as much as Nate due to not being invested as long. Ashley ended up with just over $1,156,600 and Sohn ended up with just over $1,010,300 (figures have been rounded down).
All three were smart to save, and smart to stick to their savings plan. Nate however, started the earliest, contributed the least, and wound up in the lead at age 65. Nate also contributed less of his lifetime earnings so he ended up with a nice savings balance and the use of his money during his life. Ashley was a close second. However, Sohn had to contribute a very sizeable amount to his savings during his working years.
The moral is to start saving and investing as early as possible and put time on your side. With scheduled amortized debt like fixed-rate mortgages and federal student loans, you know what you need to contribute every month. Do that, and the debt will be retired on schedule. Any extra you have should be invested due to time and the miracle of compounding.
Master your cash flow and invest any extra you have as early as you can. Do not skip your debt payments, but know the different debt types. As an independent Certified Financial Planner™, I can help you prepare a budget, debt reduction, and investment strategy. Contact me and let’s get started! #talktometuesday #education #Hireaplanner #stressfree #savings #debt #CFPPro #budget #budgeting #time #compounding