You can prioritize debt payment over investing to become debt free quicker. Or you can make the minimum debt payments. The latter frees funds to invest in a market where opportunities are volatile, but earnings can be impressive. Then there is an approach that takes the middle ground: pay down some of the debt quicker and have some left over for investment.
The below illustrates those three alternatives with hypothetical examples. But first let’s explore strategies for prioritizing debt payment.
Strategies for Paying off Debt
Most people are happier being debt free. It provides both an emotional relief and a sense of security. Research shows a direct relationship between debt and psychological well-being.1 Of course, it depends on the nature of indebtedness. For example, we have more debt tolerance for a $200,000 home mortgage than for a $10,000 credit card.
There are a variety of strategies to prioritizing debt payments. Trent Hamm writing for The Simple Dollar describes three approaches to becoming debt-free.2
1. Pay off loans by their current balance — lowest to highest.
Radio host Dave Ramsey calls this the “debt snowball strategy.” The idea is to get a quick psychological win by paying off the lower debt amounts. Ramsey points out that this can be a “big deal” for some and can be a life-changing start to become debt free.
2. Pay off loans by interest rate — highest to lowest
You make the minimum payment on all debts, but make a higher payment on the debts with highest interest. This can be a better approach mathematically in terms of saving interest rate costs. The drawback is that your highest interest debt could be the largest debt amount. It could take a longer time to pay that debt down. You have to delay the aforementioned psychological payback.
3. Pay off credit cards first
This approach recognizes that lower credit card balances improve your credit score. It’s about credit utilization, or the percentage of what you owe against the credit limit of the card: the lower the percentage, the more positive affect on the credit score.
When You Should Prioritize Investment Over Debt Payment
An anesthesiologist and blogger describes three strategies using examples of three hypothetical young doctors. The author made some assumptions (and did the math accordingly):3
- Each doctor carried $100,000 student loan debt with a 4 percent interest rate (with a monthly payment of nearly $2,000)
- Their incomes were too high to deduct the loan interest from their income taxes
- Each had a stable income and could stick to their plan
- Market gains continued at an average rate of 8 percent
- Inflation and dividend taxes were negligible because of tax sheltering, etc
- Investments were not tax deferred (Note: factoring in tax benefits when investing pretax dollars could skew the outcome in favor of investing vs. debt paydown)
Doctor #1 prioritized paying off debts. She paid off the student loan in three years and began investing $3,000 every month thereafter. After 10 years, Doctor #1 is debt free and accrues an investment amount or $334,976.84.
Doctor #2 paid only the minimum toward his debt and invested the remainder. After 10 years Doctor #2 is likewise debt free and has an investment account worth $360,209.42.
Doctor #3 employed a combination of tactics. She paid a little more than the minimum on her student loans and invested at the same time. Her student loan was paid up in 4.5 years. After 10 years her investment net worth is $345,529.58.
So, our anesthesiologist blogger did the math and showed how risk taker Doctor #2 came out ahead. Doctor #3 hedged her bets and saved some interest payments on her student loan, but earned slightly less. Doctor #1 settled for the lower return, but went for the positive psychological payoff of being debt free quicker.
This content is developed from sources believed to be providing accurate information. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.