If you are in your 30s or 40s, does this describe your financial situation?
After years of climbing the corporate ladder, long, endless nights as a partner in your company, or completing your residency or fellowship, your career is finally well established. New financial rewards come your way from a new job or promotion, big bonuses, and other compensation that often seemed impossible.
For the first time, there is a flood of financial opportunities and you have the resources to consider them. You can buy your first house – or move into a bigger one; take a vacation in Europe or buy a new car.
You can also decide between aggressively paying down debt or saving more money for retirement, but which strategy is the right choice?
Most people are naturally averse to debt. Nobody likes a big credit card balance or seemingly endless payments to cover student loans. But letting our natural aversion to debt control our decisions isn’t always optimal as part of a long-term financial plan.
Deciphering the best option is largely based on a few important factors. How to decide? Here is a process I recommend:
Make sure your financial base is solid
First, understand what I like to call the financial order of operations. Think of this concept as a financial version of Maslow’s Hierarchy of Needs, which describes people’s basic needs as a five-level pyramid with physical needs at the bottom and self-actualization at the top.
Before you decide to pay off debt or invest – things that sit near the top of your financial pyramid – make sure your foundation is in order. Start by answering the following questions:
- Do you have an emergency fund in place? It is recommended that you have enough money to cover three to six months of expenses so that you do not have to borrow if the car breaks down or another emergency arises.
- Are you paying the required balance on your debts each month not only to avoid penalties, but also to reduce principal? If not, you need to start doing it.
- Do you benefit from the counterpart of your employer within the framework of the retirement plan of your company? Maximizing your company’s contribution can earn you a substantial amount of additional retirement savings over time.
If you haven’t checked all of the above, using excess funds to accelerate debt repayment or invest more in your retirement should take a back seat for now. Remember that you cannot build a strong building on a weak foundation.
Pay off your debts first with high interest rates
While the term “high” is purely subjective, a good rule to follow is to prioritize paying off debts with interest rates above 6%-8%. For example, a credit card with a 16% annual interest rate should take priority over maximizing your 401(k) contributions. However, debts with interest rates below the above threshold require a little benchmarking to determine the optimal financial strategy.
Next, should you pay off more debt or invest?
Compare the benefits of paying down debt versus investing excess cash.
For example, if you have $5,000 of extra income, is it wise to pay off student debt with an annual interest rate of 9% or invest in a portfolio with an expected return of 6%? By investing all the money and not paying down the debt, you would have effectively lost 3%, or $150, at the end of the year. In this case, repay the debt.
However, if there is a car loan with an interest rate of 3%, the scenario is reversed: you would earn $150 by investing your excess income.
At first glance, this profitability equation seems to provide the final answer to our question. However, using this logic in our decision making may not create the most optimal strategy. A shortcoming of the above equation is that it is nearly impossible to predict investment performance. So, would it be prudent to base our financial decisions solely on mathematical equations whose solutions rely on unpredictable assumptions? In simpler terms, shouldn’t we avoid making decisions based solely on unpredictable outcomes?
Consider other non-financial factors
Most people don’t like to take unnecessary risks. You may be wondering, “Shouldn’t I always make the best financial decision, regardless of my attitude toward risk, because that will result in the best outcome?” »
The answer: It depends. The best financial plan is the one you can stick to. If student debt or a car loan keeps you awake at night, it may be better to pay off those obligations rather than investing the excess money in your budget.
Or if you want to retire early at age 50 and need to save as much as possible, it may make more sense to allocate more to savings and less to debt repayment to align more with your goals. We all have our own preferences, attitudes, risk tolerance and goals. Indeed, what matters most to you is often the correct answer.
When determining whether to invest excess income or use it to accelerate debt repayment, consider speaking with your financial advisor to develop an action plan that incorporates both the financial and non-financial factors that this decision involves. This will allow you to achieve your goals while allowing you to focus on what matters most.
Wealth Planner, McGill Advisors, a division of Brightworth
Andrew Kobylski is a wealth planner at McGill Advisors, a division of Brightworth. He joined McGill Advisors after graduating Summa Cum Laude from Virginia Tech with a degree in finance as part of the CFP® certification education option. His primary responsibility is to help develop financial strategies and recommendations for a wide range of high net worth clients across the country.