SHOULD YOU INVEST OR PAY OFF DEBT?

To invest or to pay off debt? That is the question. Hey everyone Daniel here and welcome to Next Level Life a channel where you can learn all about investing, debt, retirement, and many other financial topics besides because let's face it the schools aren't going to teach it for us. So if any of those sound interesting to you or if you want to learn about how to better handle your money and have more financial freedom be sure to hit that subscribe button and the bell next to my name to be notified every time I upload a new video. But with that out of the way let's get into today's topic. Now 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 that you don't lose out on your employer's 401k match. And that sounds great in theory but I feel that they're missing part of the point. Because we're not comparing apples to apples here. Debt carries risk and it leads to stress and in a lot of cases 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 cited money problems and money stress as the leading reason for their split. So even if you can make more money in the market than what your debt is actually costing you in interest, which sometimes you can sometimes you can't, there's also more to it than that. Again, finance is more than just the mathematics. So in this video, 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. So let's get started. Why is this even a debate? Well, I already kind of covered that with the whole BBD syndrome, I can get a bigger better deal in the market than what they're charging me in interest. And again, that is sometimes true. Say just this last year, for instance, the market was up well over 10% and with the exception of credit card bills, generally, you're not getting charged that much in interest. So there are times where you can make more in the market than what they're charging you in interest. 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 because 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, which again, if all else is equal, you don't want to lose out on your 401k match. But not everything is equal in this debate. Again, we're comparing apples to oranges because debt carries a lot of risk. It increases the amount that you have to spend every month just to survive. And what happens if you lose your job or, like I said, if the market goes down? And then, of course, there are the other impacts of debt, stress being foremost among them. But if I may play devil's advocate here for a bit, what's 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, or 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 graduated college. They're both 23 years old. They just started new jobs, and they make a combined $60,000 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 loans have a principal balance of $60,000 and an interest rate of 4.2% with a minimum monthly payment of just under $1,000 a month. They also have student loans worth $50,000, and they're being charged 4.5% interest on those. The minimum monthly payment is a little over $500 for 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, and their companies match dollar for dollar up to 3% of their income. Since their income is $60,000, that means that the company will match dollar for dollar the first $1,800 that John and Jane put in, or about $150 a month. Finally, their expenses are $4,000 a month or $48,000 a year, meaning that they have $12,000 a year or $1,000 a month to either throw at their debt or invest in the market, whichever they choose. So in this situation, what should John and Jane do? Should they invest in order to get the match, or should they focus on paying down their enormous debts and then start investing? And how much of a difference will this decision really make? Let's find out. I'll start with them deciding to invest, and we'll see where that goes. For the record, I'm going to assume that in all scenarios, John and Jane get an 8% rate of return in the market So in scenario 1, John and Jane start investing $1,000 a month plus the $150 a month match from their company. They're making their regular payments on all their debt, but nothing more, and after 5 years, they've managed to accumulate a very respectable $87,000 in their 401ks. However, their car loan still has a balance of nearly $8,000, and their student loans still have nearly $28,000 left to be paid, so their net worth is hovering around $51,000. Of course, this is 5 years into their working career, which means they're both 28 years old, so 50k is still very good. But 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 $100,000 in their 401k. Even when you take away the $24,000 worth of student loan debt, you still have a very respectable $76,000 in their net worth. And again, keep in mind, this is 5 and a half years after graduating college. Now as I covered in my how much is your car payment really costing you video, which I'll leave in the description down below, statistically speaking, almost as soon as we finish paying off our car loans, we're getting ready to sign a new one. I mean, hey, 6 or 7 years, that new car that we bought just doesn't seem as good anymore. Starting to have some problems and maintenance issues, we're ready to trade off. And who can say no to that new car smell? So I can only assume that's what John and Jane would do in this example. And for the sake of simplicity, I'm going to assume that their new car loans are the exact same as their old car loans. So they still have $1,000 a month to invest in their 401k plus their employer match. 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 $215,000. Pretty good for a couple in their early 30s. And I'm going to stop right there with this example. They got their student loans paid off and their car loans are nearly paid off at least at this point. So after this point, progress is going to be very similar to what it would have been if they had paid off their debts. And for the record, if some of you are wondering if they had not gotten a new car loan after the first one was paid off and instead got a couple of used cars for, say, $5,000, then they would have ended up with $206,000 once their student loans were paid off. So let's jump back to the beginning. John and Jane have just recently graduated college, they're 23, and they just got their first jobs. What if instead of deciding to invest, they decided to pay off their debt first and then invest? They would lose out on their 401k match as they're paying down their debts, but let's 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 two arguably most popular ones are the debt snowball made famous by Dave Ramsey and the debt avalanche, both of which I covered in a previous video, so I won't take very long to explain what they both are, but basically, the debt snowball is a strategy that states 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 that smallest debt until it's paid off in full. Then you do the same with the next smallest debt. Debt avalanche, on the other hand, says that you should order your debts from highest interest rate to lowest interest rate and pay them off in that order. Regardless of whether they're using the snowball or debt avalanche method for paying off their debt they're actually going to start with the student loans because it has both the lowest balance and the highest interest rate. So that makes it simple and just like in the previous example after making minimum payments and covering living expenses they have a thousand dollars that they can throw out their debt every month and all of that money is going to be thrown to the student loan debt which ends up getting paid off in three years. Now just as an aside here I would not advise you to stop contributing to a 401k for three years in order to pay off debt that's a very very long time to not be investing so just know this is just an example for education purposes as opposed to actual financial advice. But getting back to the example after the student debts are paid off they can now take the money that they were using to make those minimum payments as well as the money they have left over after their regular expenses and throw it all at the car loan. Now in the three years that they were paying off their student loans and only making minimum payments on their car loan the car loan did actually still go down in fact at this point it's down to about $30,000 so that's how much they're going to have to pay off from here on in and running the numbers we find that they do it in a year flat thanks to some money that was left over after finishing paying off the student loans last month. So after four years John and Jane are debt-free and they can now start investing and they actually get off to a really good start investing they put in over $3,600 in the first month again thanks to some extra money that they had left over at the end of the previous month after paying off the car loans and we jump ahead one year so five years after they had actually started paying off their debt and they have a net worth of $35,000 that puts them behind the previous example which remember had $51,000 in net worth five years in but John and Jane in this example are gaining ground rapidly in fact if we look ahead to the 10-year mark where we left the last example we see that this John and Jane managed to accumulate $248,000 in their 401k that's a whole $33,000 more than in the first example but again like I said a moment ago I would not actually advise you to wait that long to invest in your 401k even though the numbers in this example came out in favor of paying off debt I'd still rather you not have to wait that long so with that in mind I did a third example where John and Jane at the beginning sell both of those cars that they just bought for about $15,000 a piece and then they use that money to buy affordable used cars to get them to and from work while they're paying off their debts because yes I do still think that paying off debt is the right choice in most cases obviously you'll want to talk to your own financial advisor so he can look at your actual numbers but as I said earlier you also have to keep in mind that if you're just solely looking at the math you are missing part of the equation always take emotions and psychology into account now ideally John and Jane would get some part-time work as well temporarily anyway while they're paying off their debts but I did not figure that into this example mainly because I wanted to keep things as consistent as I could with these examples since they are again more for education than anything else so in this third example John and Jane pay off their student loans in 15 months and their car loans by the end of the 35th month they then started investing just like in the second example and wind up with $75,000 in their 401k at the end of the five-year mark which in terms of net worth is actually more than both the first and second examples because even though the first example where Jane and John just started investing right away even though that had more in their 401k they also had enough debt that dropped their net worth down below $75,000 and if we look ahead to the 10-year mark there is no question John and Jane have accrued $308,000 in their 401k and that's $60,000 more than the previous example and almost a hundred thousand more than if they had just started investing right away so the conclusion I drew from this is that it does seem in most cases to be better to take some time to pay off your debts both mathematically and especially emotionally even though it means you're going to be missing out on some 401k matches in the beginning now you could make the very real argument that after paying off their debts John and Jane would not be investing $2,600 a month which is what they had left over after expenses once they had no debts and that is a very very valid argument because they were living on ramen noodles and beans and rice for I mean as they're working their way out of debt yeah it's understandable they have that lifestyle but once they're out it probably ramps up a bit and that would of course alter the numbers possibly even putting the investment example ahead in terms of net worth after 10 years however there is a couple of things we do again have to consider and that's a the value of the lessons that John and Jane learned while paying off their debts as well as how their finances would look in the 40th or 45th year of their working career when they finally get close to that retirement age after going through that long of a slog trying 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 likely going to be much better at handling their money and tracking their expenses because of this experience and let's just say just for the sake of argument that they stopped investing in their 401k at the 5-year mark so basically they kept the lifestyle that they were living while paying off debt for one year and then drastically increased it after that spending like $30,000 a year more they would still have about $760,000 in their 401k by the time they reach retirement and say if they were to cut back their investing from the $2,600 or $2,700 a month that they were putting in to just $500 a month for the rest of their working career they would still end up with almost $2.4 million by the time they reach retirement so those are my thoughts on the invest versus pay off debt debate i think that in most cases paying off debt is probably the right move when you take all things into account but what do you think let me know in the comments section below and that'll do it for me today once again if you enjoyed this video be sure to subscribe and hit the bell next to my name so that you'll be notified of all my future uploads i generally upload every single friday and if you have a friend that would be interested in this kind of content be sure to share it with them let's really get this information out there and together we can start a financial revolution