How To Prioritize Paying Off Debt and Building Wealth
- Learn why science lacks real-world application in personal finance.
- Covers the importance of financial education early on in life.
- Discusses how prioritizing debt payoff and building wealth comes down to values.
A reader named Patty inquired on the Ask Todd page:
“I am aching to be free of my student loan debt (roughly $60k), so I've been religiously following a debt pay off plan thanks to your ADP calculator. At the same time, I've been struggling to put 10% of my monthly income towards savings, and another 10% towards my IRA (though, I know it's not enough). I'm 26 years old. Years away from retirement. And aching to be debt-free….
What's more important? Quick debt pay off? Or maxing out IRA contributions and saving 10% of my income?
If I cut back on contributing to my savings and retirement even 50%, I could be free of debt 2 years sooner (saving $5,000 in interest) than if I continue to save/contribute the way I am. If I were debt-free, I could travel at will, put away more for retirement later on, save for a house… Oh, the possibilities! But, then I slow down my savings and retirement accounts. Any advice?”
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Patty, first off, I want to acknowledge your clear focus and dedication to your financial goals. I'm confident you'll do well regardless of which choice you make with this decision.
Also, thank you for the kudos on the accelerated debt reduction calculator. I've put a lot of work into the free financial calculators and free retirement calculators on this web site, and I encourage every reader to make best use of these valuable resources. I use them personally and with financial coaching clients regularly.
To answer your question: the scientific, 100% accurate response is, “You should do what gives you the highest after tax return on your capital.” Unfortunately, this answer is useless for real world application.
The problem with the scientific answer is you have to know the future after tax, compound return for every investment alternative (which is impossible since the future cannot be predicted with any accuracy).
So much for science in the world of personal finance…
Related: 5 Financial Planning Mistakes That Cost You Big-Time (and what to do instead!) Explained in 5 Free Video Lessons
The practical answer is a blend of art and science. It combines the personal aspects of financial success (money habits, psychology, etc.) with proven financial principles.
I point this out because the art-science principle is going to have broad applicability to most financial decisions you face over your lifetime. Science roots your financial plan in hard numbers, while art incorporates the emotional/human aspects of building wealth. Both are important.
Putting the two together, there is a huge tax deferral value to retirement savings given your age that can never be recaptured if you don't make use of it now.
In addition, getting started early on retirement savings is one of the single smartest financial habits you can develop. I walked-the-talk on this one, and it's a major reason I was able to “retire” at age 35.
My personal bias is to always max out tax-deferred and tax free retirement savings first, unless there's a really compelling reason not to (higher after tax return elsewhere). This is just a solid rule-of-thumb.
The tax advantages provide great value over a lifetime, and the penalties provide a good fence around your fortune so you don't raid your nest egg during life's inevitable setbacks. Both are important to your lifetime wealth equation.
How you prioritize your remaining funds is a question of values. In other words, you clearly have a high emotional value on being debt free, and will likely feel a great a sense of achievement and forward momentum when you reach this goal.
The importance of this can't be overstated. Since you're already playing offense (building wealth) with your retirement accounts, it's perfectly reasonable to put on a good financial defense (pay down debt, reduce risk) with your remaining capital.
The counter-argument to the above logic would stress that student loan debt has a known cost in terms of interest rate. Post-tax, regular savings has an unknown benefit which is a function of your investment skill and market opportunity.
Therefore, it's unknown which will provide the highest after-tax return (but it's relatively clear which will provide the highest emotional return).
After weighing all the various arguments, my suggested order of prioritization, based on the limited information provided, would be to…
- Fully fund all tax-deferred retirement plans first.
- Pay down debt second with remaining capital.
- Build post-tax savings only to create a small nest egg for temporary hardship until debt is paid off, and then go big after that.
I would add one more point to this equation – you should dedicate an equal focus to building your investment skill while your capital remains small and you're paying down debt.
Learn the investment ropes now and make your mistakes early with smaller dollar amounts. The lifetime value of this early education compounded over a lifetime is literally worth a fortune to you.
Anyway, I believe this formula should strike a reasonable balance between the various conflicting needs for limited funds. It should come close to balancing both the art and science of building wealth.
What do you think? Do you agree or disagree? What principles discussed here can you apply in your own life? What did you like about this plan, and what did I miss? Share your thoughts in the comments below.
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I think tax deferred investing is oversold. Invest in the market and make sure most of your gains are long term. Do not be an active trader and you can keep your taxes to a minimum. You can offset gains each years by selling losses, and there are always losses in a portfolio, if you do it right and have negatively correlated stocks in the portfolio. Then when you need the money, it will be taxed at lower capital gains rates, instead of income tax rates. Even in retirement.
Also Todd, I get a kick out of saying you “retired” at 35. Isn’t what you are doing now work? You sell coaching and the do coaching. That is work to me.
@Steve – I’m a little thrown off by your comment…
All you’ve done is negated my choice of how to live my “retirement” and you negated the mathematical value of tax deferral and putting a fence around your fortune (even though it is a mathematical certainty without downside) by making assumptions about valid investment strategy that may or may not be true (they are not true for me, by the way).
My challenge to you is to add something positive to the discussion by sharing how you could improve upon what was stated rather than just negating. Please offer solutions that support and help.
In other words, the question posed was how to order the payoff of debts and grow savings. What helpful suggestions can you provide that would help people.
I should have been more specific. I think one should max out matching 410k’s first, then pay off revolving debt. Also, evaluate the opportunity cost of paying off low interest debt instead of investing those assets. I also should have worded my comments on your retirement differently because I didn’t mean it to sound negative, as it came out. Sorry about that.
@Steve – No problem, Steve. I just really try to keep the comments focused on adding value, and I appreciate you coming back and sharing your thoughts. No harm, no foul. Onward and upward…
@Steve: Four quick caveats with that; first if you’re in the 35% tax bracket, for instance, it’s that much money you can’t invest. Second, that you invest pre or after tax, your risk and return will be the same. Third, if you invest after tax you’ll pay 35% on the money (marginal rate) at investment and 15% of cap gain when you sell to finance your expense. If you invest pre tax, you’ll pay only 35% on what you withdraw.
Fourth, and the worst, you don’t know how cap gains will be taxed in the future. They may very well be taxed like ordinary income. Your after tax investment will be killed in that case.
Tax deferred investing is great for a portion of a portfolio. There’s only so much you can invest tax deferred anyway, and the higher your tax bracket the less likely you can do anything but add to a 401k unless you are self employed. A big shortcoming, which has been mentioned before, is that you cannot write off losses or, even more importantly , proactively offset gains with losses. So you may not have that 15% to pay after all. And a very big negative to long term pre tax investing is that when you die, your heirs do not get a stepped up cost basis at your death. That can be a huge tax, as opposed to no tax at all on after tax investments. And finally, you are right. We do not know what cap gains rates will be in the future. Nor do we know income tax rates. Income tax rates could be triple or more than cap gains rates, in which case there is less incentive.
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Hi Todd and Friends.
I’ve just been having a series of conversations with a friend on this very topic and have written an article on this as well. I stress the importance of considering that long term habits are every bit as important as paying off the debt. If fact, I believe, that paying off debt too quickly can be detrimental. Pay down debt and save simultaneously and at a point the saving will grow so big that as the debt disappears you will have no desire to go back. Get Rich Slowly says a similar thing. So Financial Mentor, Get Rich Slowly and EasyMoneyEasyLife.com are all in agreement on this one.
Good advice Todd. I agree that tax deferred accounts are the way to go, especially with a company 401K. My company has 100% matching so I would be foolish to just invest in a taxable account.
@Steve: The definition of “retirement” is different for some people. I can say I retired at 25 since I have my dream job and would do it for free. (well paid helicopter pilot with 26 weeks off a year)
However, from a financial planning point of view I am not in “retirement” as my expenses exceed my interest income and I need a salary to make up the difference. I’m glad Todd enjoys running this website instead of sitting on a beach somewhere in Mexico living off of his investment income.
@Kevin – Thanks. Yes, in most circumstances tax deferral makes sense.
In all fairness to Steve he was actually making a valid point. I just wish it was stated in a constructive way. In other words, he is correct that the tax deferral value can be overstated when you employ certain investment strategies. He could have really cemented his point by adding that tax deferral has the negative impact of transmuting long term capital gains into ordinary taxable income upon distribution meaning that for certain older savers it can actually be a negative. All those points would have added value to the discussion and helped readers better understand how to use the tools available — if the comment had been made in a constructive way.
With that said, the person asking the question is young and will almost certainly benefit greatly from tax deferral (and putting penalties for early withdrawal around her savings) for her particular situation. The points above would help people in other situations.
I like how you added the point of employer matching in a 401k. That is another no-brainer.
Regarding “retirement”, it is one of those words that needs to be replaced with 3-4 new words that more accurately describe the different definitions of retirement. For example, my definition is more in line with yours – a lifestyle business. Others view retirement as equivalent to the pro-leisure circuit. I tried that definition and didn’t like it. I’ve watched quite a few other people live that definition and not one has found joy with it.
I will write a post in the near future on this issue defining “retirement” and the various associated issues both to clarify the discussion and provide an easy link for future challenges on this topic.
BTW, flying a helicopter 26 weeks out of the year sounds like a great gig. Congratulations! That sounds like fun to me.
@Todd I would really like to read your post when you write about “retirement”. So many relate it to a “JOB”. What about “withdrawing from a particular place or activity” as retirement? Not doing what I used to do and HAD to do. My own personal retirement at 52 is about Freedom of Choice with regards to money and time. It’s about owning my own life. It’s about not having to answer to a “boss” or being chained to something. I’m busy everyday, enjoying the freedom of choice everyday and reaching into others lives & effecting them for the good.
To me retirement is not getting paid for an activity that you are doing. If someone retires and then gets involved in another venture that provides income of some sort, to me that is not retirement. Doesn’t mean I am right. It’s just how I see it. Some say do what you love and you will never work a day in your life. That may be true, but that person still is not retired. They are joyfully working.
Kevin, it seems that your two options you’ve chosen for income is “interest income” and working part-time for a “Salary”. Why? (Even though it’s your dream job). Have you considered a passive asset income like rental property income instead of “working” a part-time job?
@Todd-I look forward to seeing a post on your take of “retirement”. It is a subject that has always interested me.
I like that phrase, “Joyfully Working”.
“This is the true joy in life, the being used for a purpose recognized by yourself as a mighty one; the being thoroughly worn out before you are thrown on the scrap heap.”
– George Bernard Shaw
@Kevin – Great quote! I believe something along those lines is necessary to experience deep fulfillment – something beyond transitory, superficial happiness.
Patty, you have 2 unmentioned problems:
1. If you cannot allocate 10% to savings and another 10% toward investing there is some type of budgeting problem. The most likely source is that your housing must be 25% or less of your take-home pay or you will starve other areas of your life that need to be funded. (Find roommates or other arrangements, or add part-time weekend work to bring in more income).
2. You made a favorable investment by borrowing for your education. However, it is possible that you borrowed far too much for your degree (which I suspect given your amount of student debt and your age). The rough rule is to borrow a maximum of 75% of your expected annual salary. Since you likely over shot this, you are now seeing the results of being forced to starve other areas of your life: friends are traveling and you cannot afford to, friends are starting to save for a home and you cannot afford to, etc. This pressure is causing you to focus on this now horrific debt instead of the career that it afforded you to pay it off over time; and how fabulous your life would be if it were gone.
My best advice is to move forward sustainably, meaning allocate money to savings, retirement, and student debt principal and then don’t worry about it. Your “fun time” is delayed a little because of this debt, but that’s life. If instead you put all the money toward your debt it will starve other goals and create another crisis in another area.
If you want to be financially aggressive, you could find additional work or move in with some family members for a year to accelerate the student loan debt down. Otherwise it may help to just focus on your monthly net worth building instead of just that single liability.
I recommend that anyone continue to put money into investment accounts or it delays and stunts your investment education because you’ll have no reason figure out what to do with new money. Plus it dramatically increases the money you need to save to catch up to where you would have been to hit financial goals.
For your retirement account investing, you haven’t said which type of account it is. I’ve evaluated many specific 401K programs recently where the funds perform so poorly that even with a 100% employer match you would be better off financially by not putting any money into it! Retirement accounts are simply one location that your money should be diversified among because it has some tax benefits but many limitations. (Also, to my memory there are 8 countries have raided retirement accounts when their finances were in trouble and it has been tried many times in Washington when they want to spend more money – it is not your money until it has been taxed and there is always a probability that money in IRA’s, including Roths, may get hit with some unfavorable tax treatment.) Just like you diversify asset classes, you diversify timing, and account locations (types of retirement accounts).
I hope that these comments may help.
@Lawrence I really like the majority of the advice you provided above for Patty, but SOME of your statements are supported only by your assumptions, which leads to an opinion and arriving at your advice.
Your #1 response, I agree there probably is a budgeting problem in other areas that is not allowing for 20% to be shoe-boxed for savings and investment, but we are not given that info so we don’t know. For so many reasons already discussed by so many, I agree she needs to keep setting aside that money for those purposes.
One point being, we have no idea how much is she is having to pay on her debt and it is not indicated how long she will be paying down that debt. Will it take 4 years, 10 years or 15 years? If she doesn’t save or invest for say 15 years that it takes for her pay the debt, that would be a terrible decision as we all know, compared to say 4 years.
Your #2 response I have some issues with. You said, “You made a favorable investment by borrowing for your education.”
Couple things, it’s not technically a “favorable investment”, as her return is speculative outside of receiving knowledge and a piece of paper. If one borrows money for a favorable investment, they sure would or should do due diligence that they will be rewarded favorably with a handsome return. I would question the validity of borrowing for a degree. Unfortunately, about 70% of those graduating with a bachelors do so with an average of $30,000 in debt. not exactly the way to start “Life”.
Next, we don’t know if $60,000 was out of proportion to the degree she received and how long she went to school, that would be an assumption. Furthermore, You kind of drug her through the mud in an another assumption and compared her to “friends”, that they are living a life opposite of hers, with freedom and flexibility. Umm, how do you come up with that? Her friends are most likely her age, which statistically, they are in the same predicament. It takes students an average of 10 years to pay off school loans.
In my opinion, your best statement:
“My best advice is to move forward sustainably, meaning allocate money to savings, retirement, and student debt principal and then don’t worry about it. … If instead you put all the money toward your debt it will starve other goals and create another crisis in another area.
If you want to be financially aggressive, you could find additional work or move in with some family members for a year to accelerate the student loan debt down. Otherwise it may help to just focus on your monthly net worth building instead of just that single liability.”
I like that! In my experience, too many people focus just on paying down debt like a crazed, single-focused race horse and totally forget about even a small 3-month hardship nest egg, increasing cash flow and net worth building techniques. Twenty years down the road they wise up a little and start thinking about how much they lost all those years by not implementing good sound investment and income building strategies.
It’s not just about what do I do with what I have, but how can I increase what I have and how do I make my money work for me and be productive. My advise for Patty other than what I said above, is to think about how you can increase your cash flow outside of working your JOB. The best to you!
There is a strong possibility of hyperinflation, in which case early retirement of debt is foolish. Better to put that extra cash in gold or silver.
The previous 2 posts comment on what might be happening down the road. One worries about the government raiding retirement accounts, and the other worries about hyperinflation. If you mange by worrying about all the bad things that could happen, you would do nothing. That’s why you diversify and do not strategize based on what might happen. There will be another bear market, but that doesn’t mean you do not buy equites or fixed income now.
Steve: perhaps Todd can comment on this but aggressive net worth building could be more than than buying a diversified asset allocation mutual fund and holding for the long-term. It is a great place to start without any education, but eventually there are higher returns available for those willing to put in the time.
As for your worry comment: If there is a 1% chance of your home burning down, you do not worry about it, you simply manage that risk and purchase fire insurance. Similarly, if there is a 10% chance that interest rates have peaked, you do not fret, you respond to that future probability by increasing your allocation to bonds.
One tactic to increase returns is to scale in more when an asset class is undervalued and scale out some when that asset class is severely overvalued. As you say, there will be another bear market. So how can you capitalize on that unless you’ve freed up some cash by selling some on the way toward the peak?
Just my 2-cents, but this is getting off-topic about Patty’s particular situation.
I never mentioned diversifying by buying a mutual fund and holding. My point is do not worry about things that in all likelihood will not happen, at least not in the near future. As things begin to happen, make appropriate adjustments. Risk does not always mean better rewards. It often simply means more volatility. But this getting off topic, as you said.
Your recommendation seems to make the most mathematical sense.
But from reading Patty’s question, it seems like she really wants to be debt-free. And she already seems to have a good grasp of good financial habits.
Given this info, I would say she wouldn’t be in bad shape if she accelerated her debt-repayment and got out of debt two years sooner.
Sure, her savings and retirement nest egg would partially be on hold, but it seems like she’d be more at ease mentally and emotionally.
With her debt out of the way, she can completely focus on building her IRA and savings.
Good post Todd,
Patty would do well to take your advice on investing agressively in her tax deferred retirement option as well as paying down the student with the extra capital as suggested.
I’d like to take it one step further, if I was Patty, I’d do the above yet split up my extra payment towards the loan monthly. I would send one exra split payment in the middle of her monthly loan schedule and the other as a ‘unscheduled payment’ towards principal when the loan is due. It will cut interest and boot her confidence as she goes along.
Once she can afford to, build up a larger lump sum payment and do the same. This could knock out this student loan in possibly half the time and save her thousands in interest. Paying this off early could give her the financial boost to defer those older payments into something more fun to build wealth where the interest is on her side (compounded).
Let me share my experience with you and offer my approach.
The most important thing to consider is Todd’s statement when he says “you should do what gives you the highest after tax return on your capital. Unfortunately, this answer is useless for real world application. The problem with the scientific answer is you have to know the future after tax, compound return for every investment alternative.”
I graduated school with $240,000 in student loan debt with a 4.85% interest rate. I have the same dilemma as you in striving to be debt free but also wanting to grow wealth at the same time. I am a full-time trader (was previously in medicine which is how I racked up the loans) so I view every financial decision I make in terms of its risk:reward ratio.
For example, at 4.85% on $240,000, on the minimum payment I would be paying $11,640 a year just in interest. The question I ask is if I didn’t pay down my debt faster, would I be able to make $11,640 a year with the extra money that would have been used to pay off my loans? If the answer is yes, then it would make sense to put my money to work somewhere else because net net I would still be coming out ahead. If the answer is no, than I should put that money towards my student loans.
Let me say you are still very young and the 10% you want to save right now is not as important, in my opinion, as being debt free. I don’t know if you are married or have children, is which case what I am about to say may not apply, but being debt free is not about ridding yourself of a monthly payment. It is about giving you freedom to follow your passions and more importantly take risks.
If I didn’t have any loans, I would have been knocking on doors of certain hedge funds years ago asking for a job for any amount of money just because I wanted to be around something I was passionate about and learn from great traders. I couldn’t do that because I had to work to make a certain amount of money in order to maintain my lifestyle, support my family, and pay off my loans.
Maybe you like golf and you would like to open up a golf shop. Or you like working out and dream of owning your own gym one day. That is what I mean by taking risk, and it is difficult to take risk if you are paying money out of your pocket every month to the government.What would happen if you took 5% of your money allocated towards savings and 5% of your money allocated to your IRA and used both to pay down your debt? Would you be free 5 years earlier, maybe 10 years earlier? What opportunities would you be able to take advantage of if you didn’t have your loans hanging over your head?
Obviously, there is no right answer to your question but let me leave you with this. I have spoken to a number of people who have more money than they know what to do with and are deemed successful by any standard. If I read an amazing book, I would write the author a letter and then get them on the phone. I have emailed big time fund managers that are self-made millionaires and listened to their stories.
The absolute most important lesson I have learned from all these people is this. You have to put yourself in an environment to let good things happen to you. If you would have asked any of these people 10 years ago and told them the success they were going to achieve most of them would have laughed. But the important thing is they followed their passion and their heart, and found a way to make money doing what they love. That is true success, that is true freedom.
Let me leave you with this. Find out how many payments you are allowed to make a month and split up your payments as much as you can. I don’t pay $2,000 at the end of the month, I pay $500 a week towards my loans. There is a time value to money and making smaller payments more often is far better than paying the same amount at one time.
Good luck to you.
Why should we even need to be in this kind of debt because banks want u to be in debt weather ur educated or not its called modern day slavery
Chia Yu Ping
Do both at the same time. Surely.paying of debts is much.more crucial but investing from young.will.give you a long time horizon
I am not an alarmist, but IMO, you should pay off your debt first. If anything bad should happen to you, if you own your own home, aside of taxes, you are going to be fine. If you can’t pay your mortgage, except by drawing down on your retirement accounts with all the penalties you are worse off. If you ever decide to start your own business, you are going to need money, but what you also don’t need are bills. i would rather have a paid mortgage than money in my 401K. pay your debt, it is a (input interest rate) guaranteed rate of return. You don’t get that with any other investment.