Why is paying additional money towards high-rate debt recommended before saving extra for retirement for young people?
I've seen many advisors recommend paying extra towards high interest student loan debt before saving extra for retirement. I'm 25 years old and my self-directed retirement accounts Roth and 457(b) are in 100 percent stocks. I have some student loan debt that is 6-7 percent on a 15-year repayment plan.
Assuming a very conservative 5 percent annual growth in my retirement account, how does a dollar invested at 5 percent that is able to grow over 40 years exceed the benefits of paying off debt at 6-7 percent that will be paid off in the next 15 years?
That's a great question. And good for you for thinking so deeply about your finances at a very young age. Very impressive! Now to the question.
Here is my formula for to achieve financial freedom:
- Spend less than you make
- Save and invest the difference
- Avoid debt, especially high-interest credit card debt
A 6 -7 percent student loan debt is not what I would call high-interest debt. And if that is the only debt you carry, and you can comfortably make the payments and still save, an argument can be made to stay the course.
Here's something else to consider. If you paid off those student loans more quickly, say in 8 years vs. 15 and put the payments you were making on the loans into your retirement accounts, how much more would that add to the retirement pot?
Without the actual numbers (how much is going to your Roth and 457(b), amount of your loan payments), it's impossible to calculate the actual numbers. You can do this yourself, though. Calculate how much more you would have at your 5% rate if you put the money into your retirement accounts vs. staying on the loan repayment schedule.
And don't forget, you're adding 6-7 percent to the cost of that money every year the loan is unpaid. Look at the loan principal and payment schedule and total up the interest saved for whatever period you reduce the loan by (8 years, 5 years, etc.). That savings can also go to your retirement accounts.
I think you'll find you'll be way ahead by paying off the debt early and putting that money to work in your retirement accounts or other investments.
Kudos again for trying to get this right. I hope this is helpful. Good luck!
That's a great question and one that is asked frequently, although from the wording of your question I can't tell if you're advocating paying down debt or investing more. As a 34 year who is also an advisor I can understand your perspective, and I always encourage my clients to both invest and pay off high interest debt. To your point though, think about this in terms of dollars and not percentages. Let's say you have $100,000 in student loan debt that is charging you 6% interest or you can invest $5,500 into your Roth that is earning 5% earnings. The dollars in interest is far greater than the growth in earnings than the 1% would indicate, because of the balances in each. So if you do a calculation (there are many loan payoff and investment growth calculators online) you see that the interest saved in paying the loan off early should outpace the growth gained in the investment account. Once you pay off the debt you snowball that cash flow into more investment savings, and you're off to the races. Some folks receive a tax benefit for interest charged on student loan debt while others make too much to qualify for the deduction. If you earn too much to qualify then it's even more beneficial to pay down the debt early.
The important point I'd like to make is that I often see young professionals try to put all of their money into paying off student loans and skip over 401(k) (or in your case 457(b)) contributions. You really should put away enough to get the full employer match at a minimum, and I suggest at least 10% of salary. Then start paying off excess, high interest debt. I recently presented to residents at a med school about the importance of doing both. As with most things it seems finding a moderate balance is the way to go.
Good luck to you,
Matt Ahrens, CIMA®
Let's approach this by assuming you have only two choices: (1) pay off debt that would otherwise cost you 7%; and (2) use the funds to build a tax-deferred 457b account (this is like a 401k but for civil servants) that is known for a certainty to have a long term return of 5%.
In this case, put the money into the 457b. Why? Because otherwise you would owe income tax on it and this would more than negate the difference between 7% and 5%. Any money you put away is not taxed until you withdraw it (at age 70-1/2, 45 years from now). In addition, the funds will grow free of tax so the 5% you earn is your total net return -- and will compound very nicely.
For example, say you decide to put $10,000 towards paying off a loan. But first you owe income tax on it, so set $2,500 on fire and pay off $7,500. This avoids $525 per year in interest. If you do this you will break even after five years when the interest avoided finally equals the tax you paid. Or, put the $10,000 into the 457b. You earn $500 the first year but the earnings will compound -- that $500 will earn $25 in year two, $26.25 in year three, and so forth. After five years the $10,000 will have grown to $12,763. Even though most of your those are offset by loan interest, that's OK since the money is going to continue to compound.
Obviously this is oversimplifying the issue. You might not earn 5% exactly. You might earn a lot more or you might lose money. We can't know. But the odds are with you if you continue to contribute to the retirement account.
I usually recommend setting up an emergancy fund of cash in a savings account or money market account equal to about 6 months of bills first. Then after that is established I want to see young clients make regular committments to retirement accounts and roth IRA's to at least 10% of their income. Finally after the emergancy fund is built and 10% of income is going into retirement accounts, I then recommend paying off debts. When you pay off a debt you are basically investing at a guaranteed return equal to the interest percentage of the debt. So if you pay off a 7% note you get the same benefit as investing is something with a 7% return.
I want to see young clients accumulating retirement savings early because the two greatest investment factors are time and rate of return. The time you can never make up. I also bet your retirement funds over 40 years will average more like 8% - 10% which is much better than your 6% - 7% student loans.