Should we be paying off debt right now or investing? Simple question, but the answer can be complicated by our risk tolerance, retirement plans, and interest rates. But I have developed a system to help with this dilemma.

My proprietary solution is a set of simple equations that allow us to calculate what our financial situation will look like once we’re debt free if we stop making new investments today and use all our savings to pay off our debts.

I call it the Focus On Repaying Debt Or Don’t analysis. Or FORDOD, for short. The purpose is to take 4 financial variables, and use them to determine 3 important numbersย that we can analyse.

The 4 variables we need are..
A: How much we can save each month (\$) Includes any debt reduction eg: the principle portion of a monthly mortgage payment
B: Our total debts (\$)
C: Our total assets (\$)
D: Expected annual return on our assets (%)

Once we have those figures we can calculate the 3 important numbers. Their equations are as follows…
1) Number of years to be debt free ๐ =ย B/(A*12)
2)
Our Net Worth at the time we become debt free = C*(1+D)^B/(A*12)
3)
4% of our assets once we’re debt free = 0.04*[C*(1+D)^B/(A*12)] This tells us if we can retire on our investments using the 4% Rule which is considered a sustainable rate of withdrawal from a retirement portfolio.

Don’t worry if you’re not a math person. There’s a form below you can use to plug in your numbers and get personalized instant results without doing any algebra ๐ And by the end of this post I hope you’ll realize that although being debt free sounds pretty neat on paper, there’s often a hidden price that we have to pay for the safety and freedom of having no debt, which can cost us millions of dollars in the long run ๐

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Let’s look at an example.

Bobby is 25 years old. He saves \$500 a month from work (A).ย He graduated 2 years ago and still has \$30,000 of student loan debt (B). He has a balanced investment portfolio of stocks and bonds worth \$10,000 (C) and expects a 5% annual return on his investments over time (D). Should Bobby use his savings to pay back the rest of his student loans ASAP or invest as much as he can? We can use FORDOD to give us the following results.

It will take him 5 years to become debt free. By that time he will have about \$12.8K of assets. Using the 4% rule he can withdraw about \$500 a year from his portfolio.

Can a 30 year old person live the rest of his life on \$500 a year? Probably not. And his net worth would also be lower than average compared to other people his age. So I would personally suggest thatย Bobby should focus on investing and building up his assets more. This means Bobby will stay in debt longer and will be more susceptible to financial risks like interest rate increases or stock market corrections. But since Bobby isn’t really in a position to be financially safe and secure in the first place he can afford to take the extra risk.ย The potential upside for him to aggressively invest now is a lot greater than the risks, and arguable better than the alternative of having no debt and \$12.8K of assets at age 30.

Here’s another example. This time we’ll use me, Liquid ๐ 4 years ago I chose to invest in real estate and stocks despite still owing student loans, and luckily that decision had been the right one for me. Today we can reevaluate my situation and use my new formula to help determine if I should keep investing to grow my portfolio or scramble to pay off my debts ๐

(A)ย \$2000
(B) \$383,000 (my total debts)
(C) \$575,000 (my total assets)
(D)ย  5%

ย Here’s the analysis.

It will take me 16 years to become debt free if I pay down \$2000 of my debt each month. I will be in my early 40s by then and will have about \$1,200,000 worth of assets, making me a millionaire! Using the 4% rule I can safely withdraw \$48,000 a year from my savings perpetually.ย

Can I live on \$48,000 a year? Yes, but it probably won’t be enough to support a family if I have one by then. So based on my results I should take a balanced approach. With much more assets on the line than Bobby I can’t simply use an aggressive investment style because unlike him I have a lot more to lose. Capital preservation is more of a priority for me. At the same time I can’t be overly conservative either. So I think from now on I’ll pay down about \$1000 of debt each month and invest the rest. If we do the calculations again with \$1000 as the new value for (A) then the results are much different. I’ll have \$2,610,000 by the time I’m debt free and I’ll be able to withdraw over \$100,000 per year! Hot diggety! And that doesn’t even account for the \$1000 a month of extra money I’ll be investing. The only downside is I’ll be a lot older when I’m finally debt free but it still seems like a better compromise to me ๐

We can either become debt free sooner, or stay in debt longer to try and become a millionaire. But rarely can we do both. A FORDOD analysis can show us the opportunity cost we’d have to pay to live a debt free life sooner. It also determines how the rate of our debt repayment starting today will affect our future finances.

Someone young with no assets might discover they can afford to delay debt repayments because building a solid asset base is more important, because there’s not much to lose but there’s everything to gain.ย But once a certain amount of assets have been accumulated, like \$500,000 for example, then maybe it’s time to shift gears because once a portfolio reaches critical mass it can be left alone to compound with surprising results ๐ Meanwhile someone older who already has \$1 million in assets may findย paying off debt sooner is the best choice, because if his portfolio can grow to a size that can support him for life by the time he becomes debt free then it doesn’t make a lot of sense for him to continue holding onto debt and risk his capital.ย It’s all about risk management and most of us will have to find a balance between debt freedom vs potential future wealth ๐

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09/30/2013 4:00 am

Nice post. Your last paragraph says it all Being on the older end of these calculations and having paid off the debt at one time, I find we have been increasing our debt little by little as I have managed to consistently increase my returns these last 4 years, which means borrowing cheap to make more than I would otherwise have – or leveraging my assets. The only thing the calculations do not take into account, is the debt could be paid outright with sale of some liquid assets should a “situation” arise. – Cheers.

10/01/2013 11:53 am

Simplified into a engineering flow chart of sorts => Where you are at + some amount of Risk + some amount of time = where you want to be. The younger you understand this, the better, because as you age, the time factor keeps getting smaller, regardless of the inputs of the other 3, which is why later in life, some take on too much Risk to get where they want to be, and risk unfortunately is a 2 way street and can sometimes go in reverse and not work in your favour. So to all you young things out there, learn to set your goals early in life and understand what risk really means. – Cheers.

09/30/2013 7:37 am

What most people don’t consider in their calculations is that debt means RISK. If you lose your job tomorrow, you’ll still have debt (and probably have to pay a lot of money because of late payments and all other issues, not to mention you could lose the house/car you’re paying for), while an investment is just there and won’t ‘die’ if you cannot make payments for 6 months.

I wouldn’t consider doing ANYTHING else but paying off the debt and having some emergency fund to get me off any possible issues, till I pay it off. I was in debt and also lost my job, so I kinda know what it means to have to cover late payments, have my car almost re-possesed and similar ‘pleasures’.

So do everything you can to pay off debt and then you can invest until you’re sick of it. That’s what I did and I sleep better at night, knowing that I’ll never have to go through what I did years ago ๐

10/01/2013 9:26 am

Well, I’ve paid it off completely and am currently debt free. We also save money and are pretty well prepared for anything. My husband’s side of the business is slowly picking up, so we’ve lived off one income for 2 years now and did well. I think the fact I saw what something bad can do to your finances makes me be so ‘anti-debt’ now. I was lucky enough to be able to get myself out of it, but it could have been way worse. So I’m happy I ended it all and now, if anything happens, at least I don’t have to worry about the bank coming after me ๐

JR
09/30/2013 11:17 am

Sorry but I think your over-complicating a very simple idea. Look at it from a rate of return point of view. Long-term mortgage debt costs are approximately 4 to 5% historically. Let’s say an average of 4.5% over the next 25 years. prepaying a mortgage is like a 4.5% rate of return (provided that you invest the mortgage payment when the mortgage payment is up). This 4.5% is essentially an after-tax return. Long-term returns in a portfolio of indexes are approximately 6% real. Real as opposed to nominal. Real as in it accounts for future inflation. This 6% is before tax. After-tax at an average 25% (partially capital gains, partially income, partially dividends) puts you at 4.5%. I understand the many assumptions here including: Debt costs are closer to 3.5% currently 6% real returns is on the high side from actuarial studies 25% tax rate is just a WAG (wild a.. guess) doesn’t account for investment tools, rrsps, tfsas, resps. Sorry, but your making very large assumptions. Not everyone is an investing whiz like yourself so they may rely on portfolios of indexes or funds. Debt prepayment is a very profitable investment provided you continue to invest after the debt… Read more ยป

09/30/2013 3:35 pm

“Can I live on \$48,000 a year?”

My wife and I could, if we didn’t have a mortgage and love to travel. I figure we’ll need about \$54k per year to retire on in 2013 dollars.

Good post. I think about debt freedom vs. future wealth all the time.

Mark

10/01/2013 1:32 pm

The answer I get from the form are weird … If I save twice as much, with less debt and twice the asset than what you mention, I have less in retirement. I can only assume that’s because I can easily pay off my debt which means that when you have the mean to pay off the debt quickly, there is little advantage to worry about it ๐

At my rate, I could pay off the mortgage in 4 years. I am however diverting more than half to savings. (I wrote saving as not all of it is invested since some of it goes towards renos and trips). It’s not really invest or pay debt as we have the enjoyment section as well.

In any case, while I invest. I am also paying the mortgage faster. It’s a matter of not having a large amount at a higher interest rate later. Very rarely does someone have the money on the side to drop on the mortgage once the interest goes up. You would have to put it in your TFSA and non-registered account.

10/01/2013 5:54 pm

It’s always been a bit of dilemma for me – investing into assets vs. paying off mortgage. I’ve decided to do both – put as much as I can into savings but increase my mortgage repayment as well. The math doesn’t agree with me, but – the equity I’ve built up in my house can be put to use for investing through Smith maneuver which will accelerate my wealthy building and make my interest tax deductible. I think it will be win/win – so I don’t mind paying off the mortgage for now.

10/02/2013 6:14 am

I get weird results from the calculator. We’re going to be 100% in the black by next Christmas though. We could invest the money instead, but our remaining debt is to family and we have an obligation and time commitment to pay it back, even though it’s a super fantastic rate. (0%). From then on out, it’s wealth accumulation stage ๐ I can’t wait! It will be early 2016 when we have all of our tax vehicles full and a pile of cash to invest unregistered. I’ll be looking for some more creative choices then ๐

10/03/2013 5:57 am

Interesting approach to this issue. The only strategic point I’d note is that depending on your exact debt situation, it may be more advantageous to remove the debt overhead so you can greatly increase your asset growth. If your payments are eating up most of your monthly income, powering that down and then moving toward a balanced approach could allow you greater compounding later (because you’d have more months of larger dollars going in).

10/17/2013 8:12 pm

Very nice concise way to look at things.

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10/22/2013 11:55 am