Putting It All Together

Paying Down Debts and Building Wealth

So, let's say you are doing a great job budgeting and have some money left over at the end of the month! Should you use it to pay down your debts, save it, or invest it? We've talked about a lot of different possible uses for your funds, so how will you decide?

What you want to do, is find the most optimal way to use that money to build your overall wealth over time, while meeting your short and long term goals. Paying down debts in the right order will allow you to get out of debt faster. Keeping an emergency fund will help you prevent you from taking on future debt. Investing in the right assets will help you have the money to afford your future purchases when you think you will need the money, retire when you want, or maybe even achieve financial independence.

Sounds hard, but we don't think it has to be.

What To Do With $1,000

Let's try a hypothetical scenario. Imagine you have $1,000 left after your expenses this month. You are at least 25 years away from your expected retirement.

You have the following debts you could pay towards:

You have the following assets you can consider putting some or all of the $1,000 into:

How should you decide?

Well, we have seen how liabilities and assets grow, depending on their interest rate. So, we want to aggressively pay down debts that could get out of hand, and make sure not to miss out on investing in assets that can earn us significant funds!

In order to compare liabilities and assets in the same way, let's look for a way to use the same measurement for the rate of change of the value of each of them. We can make this easy with a small shift in thinking about the interest rate of your liabilities.

Paying down debt at a given interest rate is like getting a guaranteed return at that rate.

Why is this true? If you don't pay off this debt, it's only going to grow bigger at the specified rate. So, by paying it down, you are avoiding an extra interest charge at that rate, with 100% certainty. That's a gurantee you can't really get with any other investment!

Armed with this in mind, let's put everything together and consider debts to have a positive return rate equal to their interest rate, and a negative balance to indicate that this is money we owe and not money we have.

No Emergency Fund is Potential Debt

Hold on. In this example, this person has no balance in the Cash row, to be used for an emergency fund. We know that this is risky because if a sudden expense comes up, you might not be able to pay for it, and would have to put it on the 21% APR credit card. Yikes!

So, until the emergency fund has 3-6 months of expenses in it, let's consider paying into that a 21% return, because we are doing our best to avoid wracking up debt at 21%. After 3-6 months of interest, now you're just saving up cash beyond what you probably need, so we'll consider it at 0.90% again.

Order By Return Rate

Here is where the real magic happens. Now that we've turned all of our assets and liabilities into something we can easily compare, by giving them each a rate of return, we can just put them in order of return rate to know what we should do with our $1,000! Easy!

This is close, but actually not quite right. There are some caveats that we'll discuss below.

Caveats

Uncertainty in Investments

Some of the rows above are more certain than others. If you pay your credit card or other debt balance down, you will save the interest that you would be charged, for sure. If you invest in a CD at 1% interest, you are very likely to receive it. If your employer has promised to match your retirement contributions dollar for dollar, this is guaranteed, at least until they change their minds and let you know.

Yet, many types of investments are uncertain, as we've discussed. Stock investments become more likely to approach 10% returns over 15+ years, but this is by no means guaranteed. Bonds are similar. This should influence our decisions.

Time Horizon

As previously discussed, stocks needs 15 years to have a more confident return. If we're comparing the return of a stock investment, with a short term liability, it might be a better choice to just pay off the debt than to assume you'll make more over that time period in the stock market.

Your Goals and Future Plans

Related to the time horizon, you need to consider you own goals. Do you plan to purchase a house in the next 5 years? Then you'll need a down payment and you shouldn't invest that money into the stock market over such a short period of time. You might lose it. The same with purchasing a car or moving expenses or other plans you have. You'll need to set aside money in a shorter term investment if you have specific plans coming up that you will need it for.

Simnilarly, you have to consider where you are in life. If you are nearing retirement, you can't afford to have lots of money invested in places where the time horizon is 15+ years. You need to focus on more certain investments. However, if you are a long way away from retirement, there is a lot to be gained by prioritizing long term investments with more uncertainty.

Government Imposed Limits and Benefits

When it comes to retirement or saving for college, you will want to consider saving in tax advantaged accounts. These can have strict limits for each year, so if you don't save one year, you can't just make up for it the next. For this reason, you might decide to prioritize saving in these accounts higher.

What to Really Do With $1,000

Great, now that we are better able to think about certainty, our goals, the time horizon, and government limits, let's try this again!

This feels much better to us! If you want to get out of debt quickly and maximize building wealth, this might be a great way to approach things. Start putting your extra money into these assets/liabilities in the order they appear from top to bottom. When you reach a limit on one or pay off a debt, move on to the next row!

However, this is not the only way to order this list! We'll dive into special cases and how we applied the caveats below.

Special Considerations

While this is certainly not an exhaustive list of every possibility that can happen, we'll explain why we ordered the above list the way we did, and offer some situations in which this might not have actually been the right choice.

Retirement Employer Match Above All??

Yes, really! If your employer will match your contributions dollar for dollar, up to a limit, not doing so is throwing away free money that you will not be paid unless you contribute. This is a 100% return.

However, do keep in mind whether you have saved your emergency fund yet, and how secure you feel in your home, job, and life in general. If your current situation is quite precarious, maybe getting an emergency fund saved up would be even more important to you so you can weather a storm. But if you have someone to help you out in case the worst happens, maybe don't let this one go to waste.

Credit Card Before Emergency Fund

Our fictional saver doesn't have an emergency fund, but yet we chose to pay off the credit card before saving for one. Why?

This is because, while having an emergency fund is important, it is not certain that you will have an emergency. Assuming you have a high enough credit limit to take on more debt, in the worst case, you could charge an emergency to that same credit card you are paying off. So, now you just have more credit card debt. Yet, if you do not experience an emergency, but still save into your fund, you are forgoing paying off this very expensive credit card debt. So, we decided to pay the credit card off first, and then save for an emergency fund.

You need to be careful with this. As mentioned above, make sure you consider your situation carefully. If you do have an emergency, how would you cover it? If you are able to take on more debt with your credit card or borrow money from someone you trust, or live with a friend or relative, then this may be the right choice. However, if you feel that an emergency might put you in a dire situation, then you probably want to save your emergency fund before paying off the credit card debt.

Tax Advantaged Retirement Before Auto Loan

We chose to save in tax advantaged retirement accounts (e.g. IRA, 401(k)) before paying off the auto loan.

While the rate of return at 10% (assuming stock investments not adjusted for inflation) is uncertain, the tax savings are significant, and there are limits each year on how much you can save. For this reason, we think prioritizing savings into these accounts first makes more sense than paying off the auto loan with relatively low interest at 5.0% annually.

Auto Loan Before Stocks

If we can potentially get 10% annual return in the stock market, why would we even pay back the auto loan at 5% early instead?

For us, this is because of two things:

1. The auto loan is a guaranteed return of 5.0% by paying it off.
2. The auto loan is only a 5 year term. We have previously established that we want to save for at least 15 years to feel confident in our returns in the stock market, so we should stick with the guaranteed return of paying it off over such a short time period.

Stocks Before Mortgage

We decided that with this extra $1,000, we would be better off investing in stocks than paying extra on the mortgage. Why?

1. The mortgage is a 30 year loan. We expect that over that time period, we can safely expect decent returns approaching 10% in the stock market.
2. The mortgage rate is comparatively lower at 3.5%. Even if we don't quite make the hopeful 10% in the stock market, we feel reasonably optimistic we can make more than 3.5%.

Stocks Before Bonds/Cash

In this hypothetical, you are at least 25 years away from retirement, so you have time to make money in stocks before you need to withdraw these funds. This is why we preferred investing in stocks. However, if your real scenario is that you are much closer to retirement, or you have a big expense coming up that you are saving for like a house or car purchase, you will want to put more money into shorter term investments like bonds instead.

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