How To Prioritize Paying Off Debt and Building Wealth
- Learn why science lacks real-world application in personal finance.
- Covers the importance of financial education early on in life.
- Discusses how prioritizing debt payoff and building wealth comes down to values.
A reader named Patty inquired on the Ask Todd page:
“I am aching to be free of my student loan debt (roughly $60k), so I've been religiously following a debt pay off plan thanks to your ADP calculator. At the same time, I've been struggling to put 10% of my monthly income towards savings, and another 10% towards my IRA (though, I know it's not enough). I'm 26 years old. Years away from retirement. And aching to be debt-free….
What's more important? Quick debt pay off? Or maxing out IRA contributions and saving 10% of my income?
If I cut back on contributing to my savings and retirement even 50%, I could be free of debt 2 years sooner (saving $5,000 in interest) than if I continue to save/contribute the way I am. If I were debt-free, I could travel at will, put away more for retirement later on, save for a house… Oh, the possibilities! But, then I slow down my savings and retirement accounts. Any advice?”
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Patty, first off, I want to acknowledge your clear focus and dedication to your financial goals. I'm confident you'll do well regardless of which choice you make with this decision.
Also, thank you for the kudos on the accelerated debt reduction calculator. I've put a lot of work into the free financial calculators and free retirement calculators on this web site, and I encourage every reader to make best use of these valuable resources. I use them personally and with financial coaching clients regularly.
To answer your question: the scientific, 100% accurate response is, “You should do what gives you the highest after tax return on your capital.” Unfortunately, this answer is useless for real world application.
The problem with the scientific answer is you have to know the future after tax, compound return for every investment alternative (which is impossible since the future cannot be predicted with any accuracy).
So much for science in the world of personal finance…
Related: 5 Rookie Financial Planning Mistakes That Cost You Big-Time (and what to do instead!) Explained in 5 Free Video Lessons
The practical answer is a blend of art and science. It combines the personal aspects of financial success (money habits, psychology, etc.) with proven financial principles.
I point this out because the art-science principle is going to have broad applicability to most financial decisions you face over your lifetime. Science roots your financial plan in hard numbers, while art incorporates the emotional/human aspects of building wealth. Both are important.
Putting the two together, there is a huge tax deferral value to retirement savings given your age that can never be recaptured if you don't make use of it now.
In addition, getting started early on retirement savings is one of the single smartest financial habits you can develop. I walked-the-talk on this one, and it's a major reason I was able to “retire” at age 35.
My personal bias is to always max out tax-deferred and tax free retirement savings first, unless there's a really compelling reason not to (higher after tax return elsewhere). This is just a solid rule-of-thumb.
The tax advantages provide great value over a lifetime, and the penalties provide a good fence around your fortune so you don't raid your nest egg during life's inevitable setbacks. Both are important to your lifetime wealth equation.
How you prioritize your remaining funds is a question of values. In other words, you clearly have a high emotional value on being debt free, and will likely feel a great a sense of achievement and forward momentum when you reach this goal.
The importance of this can't be overstated. Since you're already playing offense (building wealth) with your retirement accounts, it's perfectly reasonable to put on a good financial defense (pay down debt, reduce risk) with your remaining capital.
The counter-argument to the above logic would stress that student loan debt has a known cost in terms of interest rate. Post-tax, regular savings has an unknown benefit which is a function of your investment skill and market opportunity.
Therefore, it's unknown which will provide the highest after-tax return (but it's relatively clear which will provide the highest emotional return).
After weighing all the various arguments, my suggested order of prioritization, based on the limited information provided, would be to…
- Fully fund all tax-deferred retirement plans first.
- Pay down debt second with remaining capital.
- Build post-tax savings only to create a small nest egg for temporary hardship until debt is paid off, and then go big after that.
I would add one more point to this equation – you should dedicate an equal focus to building your investment skill while your capital remains small and you're paying down debt.
Learn the investment ropes now and make your mistakes early with smaller dollar amounts. The lifetime value of this early education compounded over a lifetime is literally worth a fortune to you.
Anyway, I believe this formula should strike a reasonable balance between the various conflicting needs for limited funds. It should come close to balancing both the art and science of building wealth.
What do you think? Do you agree or disagree? What principles discussed here can you apply in your own life? What did you like about this plan, and what did I miss? Share your thoughts in the comments below.
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