Hello everyone, Daniel from Next Level Life here. I write about investing, debt, retirement and many other financial topics. Let’s face it, the schools aren’t going to teach it for us. Any of those topics sound interesting to you? Learn how to better handle your money and have more financial freedom below.
Employer Matching 401k vs Paying Debt
I’ve seen a lot of articles online talking about whether you should invest your money or pay off your debt first, and then invest your money. They all seem to say that you should invest, so you don’t lose on your employer’s 401k match. That sounds great, in theory. But, I feel that they’re missing part of the point.
Apples to Oranges?
We’re not comparing apples to apples here. Debt carries risk, and it leads to stress. In many cases, it leads to marital problems. In fact, there have been many studies that say that financial problems, especially debt, is the leading cause of divorce in America. One such study from Citibank finds that 57% of divorced couples sited money problems and money stress as the leading reason for their split.
Even if you can make more money in the market than what you’re debt is actually costing you in interest, which sometimes you can, sometimes you can’t, there is also more to it than that. Again, finance is more than just the mathematics. In this article, I’m going to be talking about why this, “Invest or Pay Off Debt” topic is even a debate. I’ll go through the math behind the question and then I’ll talk about the conclusions that I drew from my research.
Why is this even a debate? Some people say they can get a bigger, better deal in the market, as mentioned above, where the employer matches the 401k. Last year, for instance, the market was up well over 10%. With the exception of credit card bills, generally you’re not getting charged that much in interest. There are times where you can make more in the market than what they’re charging you in interest.
Market Crash Negates 401k Benefits
However, if we look back as recently as the crash of 2008, which we can’t really predict, there are also times when you aren’t going to make more in the market than what you’re getting charged in interest. The market is very volatile and unpredictable. The other reason that this is a debate is the idea that you don’t want to lose out on the 401k match, because it’s free money. Again, if all else is equal, you don’t want to lose out on your 401k match. However, not everything is equal in this debate. Again, we’re comparing apples to oranges. Debt carries a lot of risk. It increases the amount you have to spend just to survive. What happens if you lose your job, or (like I said, if the market goes down). Then there is what I call the “other impacts of debt”, stress being foremost among them.
If I can play devil’s advocate here for a bit, whats more, I’m not even sure that it makes much of a mathematical difference over the long run, whether you invest or pay off debt. At least, not as big of a difference as people seem to think. Let’s get into the math.
Let’s take John and Jane. They’re a married couple that just recently gratuated college. They’re both 23 years old. They just started new jobs and they make a combined $60k a year. As a treat for graduating college and getting a new job, they each got new cars. Of course, being fresh out of college, they didn’t have the money to pay for the cars in cash, so they signed a loan. When combined, the two loan have a principle balance of $60k, and an interest rate of 4.2% with a monthly interest payment of just under $1k per month. They also have student loans worth $50k. They’re being charged 4 1/2% interest on those. The minimum monthly payment is a little over $500 with the two of them combined. Assuming they don’t pay them off early, the student loans will be around for 10 years. Both John and Jane have 401k plans at work. Their company match, dollar for dollar, up to 3% of their income. Since their income is $60k, that means the company will match, dollar for dollar, the first $1800 that John and Jane put in. On average, that’s about $150 per month. Finally, their expenses are $4000 per month, or $48k per year, meaning they have $12k a year, or $1k per month to either throw at their debt, or invest in the market, whichever they choose.
In this situation, what should John and Jane do? Should they invest to get the match, or should they focus on paying down their enormous debts and then invest? How much of a difference will this decision really make? Let’s find out.
John and Jane Invest instead of Pay Off Debt
We’ll start out with them deciding to invest and see where that goes. For the record, I’m also going to assume that all scenarios, John and Jane receive an 8% return in the market on average. In scenario one, John and Jane start investing $1k per month, and their employer contributes $150. They’re making their regular payments on all their debt and nothing more. After five years, they’ve managed to accumulate a very respectable $87k in their 401k. However, their car loan still has a balance of nearly $8k, and their student loans still have nearly $28k left to be paid. They’re net worth is hovering around $51k. Of course, this is 5 years into their working career, which means they’re both 28 years old, so 51k is still very good.
Let’s jump ahead to the moment when their car loan would be paid off in full. The average car loan lasts 68 months, so I’m going to assume, just for the sake of this example, that’s how long their car loans lasted. At 68 months in, they have over $100k in their 401k. Still pretty good right? I think so anyway, they’re 28 1/2 years old. Even when you take away the $24k in student loans debt, you still have a very respectable $76k in their net worth. Again, keep in mind, this is 5 1/2 years after graduating college. As I covered in my, “How much is your car payment really costing you” article, statistically speaking, almost as soon as we finish paying off our car loans, we’re getting ready to sign a new one. 6 or 7 years, that new car we bought just doesn’t seem as good anymore. It’s starting having problems and maintenance problems, we’re ready to trade up. Who can say no to that new car smell? I can only assume that is what Jane and John will do in this situation.
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For the sake of this example, we’re going to assume that the new car loans are the exact same as their old car loans. They still have $1000 to invest in their 401k, plus their employer match. Nothing has really changed. Let’s jump ahead to where their student loans are paid off. 10 years into their working careers, John and Jane have managed to save $215K. Pretty good for a couple in their early 30s. I’m going to stop right there with this example. They have their student loans paid off and their car loans are nearly paid off at this point. After this point, progress is going to be very similar to what it would have been if they had paid off their debts. For the record, if some of you are wondering if they had not gotten a car loan after the first one was paid off, instead got a couple of used cars for 5 grand, then they would have ended up with 206k once their student loans were paid off, so it doesn’t make a huge difference in this example.
John and Jane Pay Off Debt Instead of Invest
From the beginning, John and Jane just graduated college, they’re 23, they just get their first jobs. What if, instead of deciding to invest, they decide to pay their debt off first and then invest. They would lose out on their 401k match as they’re paying down their debts, but lets see how much of a difference that really makes. The first question that needs to be answered is, “How are they going to pay off their debt?” What strategy are they going to use.
The most popular ones are “Debt Snowball” and “Debt Avalanche”, both of which I covered in a previous article. I won’t take very long to explain what they both are, but basically the debt snowball strategy states that you should list your debts in order of smallest to largest balance, make minimum payments on all but the smallest debt, and throw every extra penny you have at the smallest debt until it is paid off in full. Then you do the same with the next smallest debt.
Debt Avalanche, on the other hand, states that you should list your debts from highest interest rate, to lowest interest rate, and pay them off in that order. Regardless of whether they’re using the debt snowball or debt avalanche method, they’re both going to start paying off their student loans because they are both the smallest balance and largest interest rate. That makes it simple. Just as in the previous example, after making minimum payments and covering living expenses, they have $1000 they can throw at their debt every month. All of that will be thrown at the student loan debt, which will be paid off in 3 years. As a side note here, I would not suggest you start contributing to a 401k for 3 years in order to pay off debt. That’s a very long time to not be investing. Just know, this is an example for education purposes as opposed to actual financial advice.
Getting back to the example, after the student debts are paid off, they can now take the money they were making to make those minimum payments, as well as the money left over after their regular expenses, and throw it all at the car loans. In the 3 years they were paying off their student loans and making minimum payments on their car loan, the car loan did actually still go down. In fact, at this point, its down to about $30k. That’s how much they’re going to have to pay off from here on end. Running the numbers, we find out they are able to pay it back after a year flat. That’s in thanks to money left over after finishing off paying student loans. After 4 years, they are debt free and can start investing. They get off to a good start investing. They put in over $3600 in their first month, thanks to money left over from the previous month after paying off the car loans.
We jump ahead one year, 5 years after they started paying off their debt, and they have a net worth of $35k. That puts them behind the previous example, which (remember) had 51k in net worth 5 years in, but John and Jane in this example are gaining ground rapidly. In fact, if we jump to the 10 year mark, we notice this John and Jane manage to accumulate 248k in their 401k. That’s a whole $33k more than in the first example. Again, like I said a moment ago, I would not advise you to wait that long to invest in your 401k, even though in this example it came out in favor of paying off debt.
I’d still rather you not have to wait that long. With that in mind, I did a 3rd example where John and Jane, at the beginning, sold both of those cars they just bought for about $15k each. They used that money to buy affordable used cars to get them to and from work while they’re paying off their debts. Yes, I still think paying off debt is the right choice in most cases. Obviously you will want to talk your financial advisor so he can look at your actual numbers. You have to keep in mind, if you are strictly looking at the math, you’re not looking at the full equation. You need to look at psychology in order to have the full scope of the situation.
I do think that John and Jane should have gotten side jobs to help them pay off their debt, but I did not list it in this example because I wanted to keep things as consistent as I could with these examples. These examples are more for education than anything else.
John and Jane Pay Off Debt Quicker
In this third example, John and Jane pay off their student loans in 15 months. Their car loan is paid off by the 35th month. They then started investing, like in the second example, and would up with $75k in their 401k at the end of the 4 year mark. In terms of net worth, it’s more than the first and second example. Even in the first example, where Jane and John started investing right away, even though that had more in their 401k, they also had enough debt that dropped their net worth down below $75k. If we look ahead to the 10 year mark, there is no question. John and Jane managed to accumulate over $308k in their 401k. That is $60k more than the previous example, and almost $100k more than if they just started investing right away.
Conclusion, Better To Pay Off Debts First
The conclusion is that it does seem, in most cases, to be better to take some time to pay off your debts. This is both mathematically and emotionally. Even if it means you’re missing out on some 401k matches in the beginning. You could make off the real argument that after paying off their debts, John and Jane would not be investing $2600 per month which is left over after they pay off their debts. That is a valid document, because they were living on beans and rice. As they’re working out of debt, that’s understandable to have that life style. Once they’re out, that would certainly ramp up a bit. That would affect the numbers if they decided to not invest as much, possibly even putting the investment example ahead after 10 years.
There are additional things to consider, which include the lessons that John and Jane learned while they were paying off their debts, as well as how their finances would look in the 40th or even 45th year of their working career when they get close to that retirement page. After going through that long of a slog to pay off that much debt, you can bet John and Jane are really going to think hard about going into debt again in the future. They’re going to be much better at handling their money and handling their expenses just because of this experience.
Let’s say they stopped investing in their 401k at the 5 year mark. They kept their lower life style for those initial 5 years, but afterward they started spending upward of $30k per year. They would still have around $760k in their 401k by the time they reach retirement. Let’s say they cut back their investing from the $2600 or $2700 per month to just $500 per month for the rest of their working career. They would still end up with almost 2.4 million by the time they reach retirement.
Those are my thoughts on the invest vs pay off debt debate. I think that, in most cases, paying off debt is probably the right route when you take all things into account. If you need a payday loan, consider getting yours at Kiwi Cash. Their pool of lenders may have a solution to your current financial crisis.
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