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 😉
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.
Nice to hear the perspective of someone who has gone from debt free to taking on more debt over time at cheap borrowing rates 🙂 The majority of people usually go the opposite way from having debt to paying it all off, but then again, the majority of people can’t retire early like you 😀 This isn’t the early 1990s when mortgage rates were double digits. Whenever see above average interest rates again we can always just sell some liquid assets like you suggest to pay back our debts. As long as we have a positive net worth and a diversified portfolio we can always adapt.
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.
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 😉
Sorry to hear about your vehicle almost getting repossessed 😕 That must have been a tough situation for you. I hope things are better now. I think sometimes Canadians like myself are spoiled by our relatively stable markets and refuse to believe how sensitive our economic security really is. We didn’t have a major real estate collapse like the US and Europe did, we have more jobs now than before the recession, and our stock markets have mostly recovered from the 2008 correction. This may give us a false sense of vanity. Sometimes we don’t think about less fortunate people in other parts of the world. You’re so right about debt being a risk factor. If I had gone into the same level of debt in Spain or some other European country then I would probably have a negative net worth today, not to mention I’ll have a greater probability of being unemployed which definitely won’t make matters any better lol. When I read about Ireland’s home prices dropping almost 50% between 2007 and 2009 I can’t help to think, “what if that happened here at home?”
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 😀
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 »
Thanks 🙂 you’ve taken my whole post and pretty much simplified it down to the fundamentals 🙂 I admit I made some assumptions, but I like your 4.5% interest rate and return rate scenario. If we pretended that was indeed the case then I wonder if most people would agree that making 4.5% after tax in a balanced index fund is a better choice than paying down a mortgage with a 4.5% interest rate. On the surface it may seem like they cancel each other out, but like you said the investment return is after inflation, while the mortgage interest isn’t 😉
And me an investing whiz? Oh stop it you 😳 Ahaha.
“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.
It’s certainly important to consider. Too many people are so focused on just paying down debt they lose site of the bigger picture.
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 🙂
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.
Yeah, how long it takes us to become debt free has a large impact on how much those assets will be worth. I wouldn’t want to be in a situation where I’m strapped for cash when interest rates are are going up. That’s what happened to many people in the US in 2007 and they were left underwater on their homes. I have a gut feeling the Prime lending rate in Canada is going to stay below 3.5% until at least 2016. When rates have been so low for so long even a small increase can have a dramatic short term negative effect on the economy, even though it’s necessary for long term stability.
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.
That’s my plan too, using equity in my home to invest and build wealth :0) That’s nice you are able to find your balance as well.
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 🙂 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 🙂
That’s great you can max out your tax efficient accounts in a couple of years. I don’t save enough to contribute the maximum to my retirement account, but I plan to make up for it in my 30s and 40s when I’ll have more disposable income and more savings hah 🙂
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).
Great point, we all have different debt situations 🙂 And sometimes even the same person will want to tackle their debts differently at different stages in their lives.
Very nice concise way to look at things.
Thanks DG 🙂
I like your approach but your calculation could definitely use some work to make it fully comparable. If you only paid $300 per month you’d be worth more than $100M by the time you’re debt free! You’d also be long dead as it would take you more than 100 years to get there. I do agree there is something to be said for keeping debt and investing, particularly as inflation will tend to eat away at your debt overtime. It might make more sense to have a cut-off number of years – say you’re 25 and your timeline is another 25 years to retirement age of 50 (I can’t imagine someone like yourself wants to wait till he’s 65 to achieve complete financial independence). Then your calculation would compare what your net worth would have been had you achieved debt freedom earlier in life and then began putting all of your savings into your investments. I’ve prepared a calculation that would take this into account and the difference between what your net worth would be at aged 50 if you (A) paid $2k towards debt per month and (B) paid only $1K towards debt. The only assumption I’ve added on… Read more »
Thanks for the new insight LTH 😀 It’s always good to look at situations from a different angle. Good to know that when I’m retired at 50, I could have over $2M in situation (B.) What I like about this model is even though I’ll still have debt, I could easily pay it all off and remove the risk entirely, and still be wealthier than aiming to pay off my debt sooner as in scenario (A.) The extra risk for the higher return in (B) obviously still exists since there’s no free lunch, but it’s just spread out over a long period of time 🙂
You must be working for a prestigious financial institution or something because with analytical skills like yours they’d be nuts to not hire you 😉
Thanks for dropping by.
It’s funny how many people fear Investment Debt, which in the hands of a shrewd investor, the path to great expansive wealth is accelerated; while at the same time, welcome Consumer debt to afford useless crap, Even the wisest money manager would be hard pressed, stifled, and very possibly end up crippling his future prospects.
*side – I was looking at your income/expense page and was wondering if the 2014 column that says ‘estimate only’ turned out to be the final numbers. Thanks for clarifying! 😉
Thanks for the article!