Here’s one true hack I’ve utilized to increase my net worth over $7,000 in 2015 and again another $7,000 in 2016. I’ll dive into the details below but here’s the conclusion: investing always wins. So, the next time you’re asking yourself if you should invest or pay down debt, then click back to here and read below.
Invest or Pay Down Debt: Why Investing Always Wins
How can I guarantee a better option when everyone knows paying down debt is a great route?
“Paying down debt is a guaranteed return while investing is a gamble and can’t promise you anything!”…I hear you, and if you’re concerned about the risk, then read on.
I can show you the numbers and you can decide for yourself.
Most Millennials have it backwards: They place getting rid of debt as a higher priority than maximizing wealth.
The result is payment of tax efficient debt in a tax inefficient manner. This approach lessens the opportunity to achieve financial independence or early retirement.
An extra $1,000 to pay off a mortgage or student loans means you’ll save $50 on interest, assuming a 5% interest rate. If you place the same income into your 401(k) then it is pretax, so $1000 is actually ~$1,300 (25% tax rate). Adding in $40 net interest because and you’re saving $260.
With the second tax-efficient approach, you’re saving an extra $210 on your $1,000 decision for an immediate 21% return.
Compare this with the less effective, non-Distilled-Dollar approved approach of spending $1,000 to eliminate a $50 expense, or a 5% return.
What About Taxes?
If you’re concerned about the future tax costs, then check out this article on how to access retirement funds early. With strategic financial and tax planning, we can experience a $10,000 net worth increase in a year or two.
As mentioned above, the net benefit on interest is often slightly lower if we decide not to pay off the loan. In the 5% example above, the $50 spent on interest earns me a $10 reduction in my total tax bill. So the net benefit is $40 when compared with the alternative approach of investing and gaining that $10 benefit.
Outside of the monetary gain, the intangibles of utilizing the tax system while investing in your future have a positive impact on any individual, and in many cases, a couple or a family.
When I think of, “What makes me excited about personal finance?”…the clear answer is strategies such as this one!
Applied on a personal level, this strategy has increased my net worth by an extra $14,000 in the previous two years alone.
More importantly, strategies such as investing first have removed the stress of student loan debt in my relationship & it has given my fiancee and I confidence that we’re ready for the next steps in life (e.g.. home ownership, family, taking care of our parents, adopting our third-fourth-and-seventh-cat, etc.).
What about Lower or Higher Interest Rates?
With lower interest rates, this approach works even more effectively because the threshold for stock dividends has typically been around 2% in the past. What this means is a $1000 investment in Vanguard’s Total Stock Market Index (also called VTI) will net us approximately $20 in dividends payments in the year. This is completely separate from the exposure we experience as markets move up and down.
With higher interest rates, of say 10%+, then I would STILL suggest this approach because we have options to refinance.
If you’re concerned about a total inability to refinance because you recently went through a bankruptcy for example, then I would advise paying down the debt first. If you have any chance of refinancing, then consider this approach if you want to optimize your net worth instead of focus on eliminating debt only.
So the next time you’re thinking on how to pay down debt to maximize your net worth, then consider the hybrid approach and think of the numbers above: Invest what we can today and let low interest debt fuel our path to early retirement.
Do you prioritize your investments and your net worth over your debt? Are you focused first on destroying debt before moving into the investment territory (if yes, reread this post and start investing!!)?