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 numbers 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 😀 = 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 🙂 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 😕
Let’s look at an example.
Bobby is 25 years old. He saves $500 a month from work (A). 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 that 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. 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 😀 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 🙂
(B) $383,000 (my total debts)
(C) $575,000 (my total assets)
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.
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 🙂
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. 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 😀 Meanwhile someone older who already has $1 million in assets may find 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. It’s all about risk management and most of us will have to find a balance between debt freedom vs potential future wealth 😉