The question of which is most important, saving and investing money, or, to pay off debt, is much like the age old question: Which came first, the chicken or the egg? Cases for both answers have been convincingly made. For some, this question is easy and they pick either saving or debt reduction as first priority and do it. But to others, the lack of clarity as to the priority has cause them to pause, or even worse, caused them to not act on either priority. So where do you start to answer the question? I think it starts with understanding why we save or eliminate debt. We save and/or eliminate debt to obtain financial freedom. Financial freedom defers for each person, but it is rooted in having the resources to pursue one’s goals and dreams. This financial freedom allows us to be free from worry and concern over money and be free to achieve our long term goals.
Financial freedom, in most circles, is predicated on four main principles, which include saving and investing to build wealth and eliminating debt. The other two core principles are living within a balanced budget and insuring against disaster. It is the first two principles, building wealth and eliminating debt, that sometimes get at odds against each other. Because many times, debt reduction and savings for investment compete for the same dollar in our budget. It’s a common dilemma that goes something like this: If I only have limited money available to achieve financial freedom, is the priority to pay off my debts or should I save and invest the money to earn a decent return? On the one hand, we have debt, the wealth killer that is to be avoided or eliminated as a top priority. On the other hand we have the need to invest to build wealth to fund our goals and dreams. Both actions are paramount for financial freedom. But which action is the MOST important? Which action comes first?
The Case For Eliminating Debt First
Debt is an obligation that assumes we know, and can control, the future, in that debt requires regular payments over time which we can’t 100% control. Job loss, natural disasters and health issues can interrupt future payments. Debt is also expensive. Here’s some examples: Home mortgages cost us 4% (Interest rate on the money borrowed) and it only gets more expensive from there: Car loans and student loans are between 3%-7%, and the worst, credit cards, cost anywhere from 10% to 25%. This means that the couch that we purchased on a credit card for $1,000 and made minimum payments on for many years ended up costing us about $2,400 in all. In essence, we had to pay a fee of $1,400 to borrow $1,000 for the couch. Ouch, that’s expensive. And in comparison to the return on money invested in most safe investments, like money market accounts, certificates of deposit or savings accounts, which only pay a percent point or two in interest at most, most debts are more costly than any safe investment return received. So one could argue that paying off our debts is the top priority.
The Case For Investing First
Building wealth, another core principle in financial freedom, is about investing early and often and letting compound interest work over time. It is imperative to start as early as possible, so we should make saving a priority. In addition, the return on investment for blue chip equity investments, like an S&P500 index fund, is higher (averaging over 10% per year including dividends over the past 75 years) than the cost of some debt that people carry, like student loans, home mortgages and car loans. So, it could be argued that it is better to invest the money than to use that same money to pay down debt which has a smaller return. In other words, if I can make 10% on my investment, why would I instead pay down debt that only costs me between 3% to 7%?
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What’s The Smart Decision For Financial Freedom?
The answer to the question: Should I pay off my debt or save for investment to build wealth?, is rooted in the current condition of the four main principles of financial freedom mentioned previously:
- Live within a balanced budget
- Insure against disaster
- Building wealth
- Eliminating debt
If you’re reasonably insured against disaster (have an emergency fund) and you’re living within a balanced budget, then eliminating debt is the top priority. But if you don’t have both an emergency fund or a sustainable balanced budget, then the priority shifts to getting those right before attacking the debt. Let me explain a good way to approach it.
Step #1: Start an emergency fund. Do you have an emergency fund? If you have no emergency fund, then the first priority is to save up at least $1,000 in an account for emergencies. Why is this the first priority? Because an emergency fund is savings to PREVENT further debt associated with any unexpected emergency. It is self-insurance, a key component of financial freedom. We’re not done with the emergency fund quite yet. More on this later. To recap, the first priority is to establish an emergency fund if you do not have one. If you already have $1,000 saved in an emergency fund, or better yet, your emergency fund covers 3-6 months of expenses (discussed later) then skip this step and go straight to step #2.
Step #2: Eliminate debt. Within the confines of a balanced budget, treat consumer debt with extreme prejudice. What does that mean? It means after a minimal emergency fund is established, the next priority is to eliminate the consumer debt (and a commitment to stay out of consumer debt). How would I do it? I would list all my consumer debts (all but the mortgage for now) and rank them by the interest rate paid on each. Then I would pay the minimum amount on all debts except for the one that has the highest interest rate. That one I would pay as much as possible (while keeping a balanced budget). Personally, I would cut back on my lifestyle and use that saved money to make as big a payment as possible each month until it is eliminated, all the while staying within your budget. Here’s an example using the chart below:
This person has three debts, with amounts ranging from $1,000 to $5,000, and through squeezing his budget, can allocate $500/month towards paying down his debt. In the chart below you can also see interest rates and minimum payments. The first step it to prioritize the debt by interest rate. In this case, the first priority is the Visa card at 16%, then the MasterCard and last the Student Loan (See Priority Column). At this point, we pay the minimum payment to all debts except for the top priority. So we pay $125/month toward the MasterCard and $50/month toward the Student Loan. But the top priority, the Visa card, gets ALL of the remaining money available that month for debt reduction, the balance of the $500. In this case, that is $325 ($500 – $125 – $50 = $325). $325 is far more than the minimum payment requested, $60, so the pay off of this loan will be hastened. At this rate, the $1,000 Visa debt will be paid off in full in four months, at which time the payment amount of $325/month gets moved to the next highest priority, the MasterCard. That will make the MasterCard monthly payment $450, while keeping the Student Loan payment at $50/month. Once the MasterCard is paid off, about five months later, all the money will be put towards the Student Loan. In all, using this method called a Debt Avalanche, it will take 18 months to fully pay off all the consumer debt.
|Debt Pay Off Plan||Available to pay down debt: $500/month|
|Debt Name||Amount Owed||Interest Rate||Minimum Payment||Priority||Suggested Payment|
|Visa Credit Card||$1,000||16%||$60||1||$325|
|MasterCard Credit Card||$2,400||12%||$125||2||$125|
Step #3: Start serious saving! At this point, we have no consumer debt and $500/month which was used to pay off the debt available to save and invest. But invest in what? There is a priority in your savings and investment. If all you have is the initial emergency fund discussed in step #1, of $1,000, the top savings priority is to build up your emergency fund to self insure against disaster, which could return you to debt. How much is enough? The standard answer is somewhere between three and six months of household expenses, depending upon your risk tolerance. For instance, if your monthly household expenses total $5,000, then your emergency would need between $15,000 and $30,000.
Once your emergency fund is fully funded, it is time to start funding other priorities, starting with retirement. Why is retirement the second priority? Three reasons: first, a retirement account like a 401K, SEP or IRA requires a large amount of time to build up to meet your long term needs. Nothing like compound interest over time to build your nest egg. Second, a retirement account is tax preferred, meaning not only are you saving but you are paying less taxes all the while. Third, many retirement accounts offered by employers have a match program where the employer matches a portion of the savings you commit to your retirement account. In essence, this is free money given to you by your company which then will return interest in your account. How much is enough retirement savings? It is recommended that the full amount by law be saved and invested in a retirement account, roughly 15% of your net spendable income each month.
What’s next after the emergency fund is full and we are meeting our retirement savings needs? If you have children and plan to financially help them attend college, you need to set up and fund an education fund, like a 529 plan, and then contribute an amount that will meet your financial goals and timeframes. We are still not done saving yet. We need to save and invest for future needs too. Cars, homes, vacations and furniture are just some of the things we need to save for so that we don’t go back into debt when it is time to purchase them. In all, there are a lot of things to save for, but using a prioritized approach will ensure you don’t go (back) into debt when an emergency occurs or a large expense is required.
Some Sage Advice
Warren Buffett is credited with some really sound advice on the topic of saving. To obtain and maintain financial freedom in our lives, he said we need to “spend what’s left after savings, not save what’s left after spending.” Here is where the balanced budget comes into play. It is crucial that we first factor savings into our budget to ensure our goals and dreams are being financed and to keep us from going into debt. Then, and only then, can we determine what we can afford in the way of monthly expenses. So often, people build up a lifestyle that is comfortable, only to find out they can not afford the savings needed to fulfill their dreams. They save money after they finish spending. Then find out there is not enough money left over to save! Make a budget, save first, then spend while not exceeding your income.
There you have it. The answer is quite straightforward, though it is not as easy as deciding between saving or paying down debt. The flow goes like this: Develop and maintain an emergency fund, then eliminate consumer debt, before saving and investing for your dreams and goals in life, including retirement, children’s education, homes, cars, vacations, etc. AND, all of this must fit into a balanced, sustainable budget in order to experience financial freedom. Financial freedom, it’s not easy, but it worth it!