Prioritizing Debt vs. Investing

It’s been three years since my wife and I began our path to financial freedom. In that time we’ve paid off $130,000 of debt, but at last count we still owe over $388,000. So how can a couple so deep in debt title a post about prioritizing debt vs. investing? Is it really a discussion? It’s an easy decision to throw every spare cent at our debt to pay down that balance and worry about investing later. Right?

It would certainly be less scary to focus on debt reduction. It would be simpler to forget about investing and only focus on getting back to being debt free.

In spite of these perfectly rational arguments, we prioritize pre-tax retirement savings even before attacking our mountain of debt.

Our debt balance starting in the fall of 2005 to early 2017.

The traditional advice for how to prioritize debt vs. investing goes something like this:

  1. Invest in company 401k to receive employer match
  2. Debt Reduction
  3. Continue company 401k and/or IRA
  4. Taxable/Savings

And this makes sense. Assuming a full company match up to a certain percentage, an immediate 100% return by investing in your 401k doesn’t make sense to pass up. Beyond that, the general consensus is to get your act together and eliminate your debt while taking advantage of the guaranteed return that comes with it before considering other investment options such as continuing to fund your company 401k and/or funding an IRA before finally moving on to taxable accounts.

Our strategy is a bit different as we start by prioritizing fully funding our 401k (and HSA) before moving on to debt reduction, and while I’ll do my best to quantify the reason below, I think it can be best summed up with the following:

It allows us to keep and put to use as much of our income as possible.

The Math:

As an engineer and a dentist, our combined annual income put us in the 33% marginal tax bracket for each earned dollar above $231,451 for the year 2016. Let’s assume we made $36,000 more than this and that we each have the option to contribute a maximum of $18,000 into a 401k, for a total of $36,000 between the two of us.

So for us, the question comes down to this:

Would we rather invest $36,000 in a tax sheltered retirement account or lose 1/3 of this sum to taxes and use the remaining $24,000 to pay down the balance of our student loans?

Even if we disregard any company match that comes with investing that $36,000, and even before comparing the possible investment return vs. the three point something interest rates on our student loans, the decision is pretty easy. . . for us.

In order to maximize the impact of our earned income, we fully fund our pre-tax retirement accounts and focus on debt repayment with the rest. Our personal debt vs. repayment strategy looks like this:

  1. Fully fund pre-tax retirement accounts and HSA
  2. Debt Reduction

For now, that’s it. We’ll concern ourselves with taxable accounts at a later time. I’ll add the caveat that we’re currently (for the next few months) deviating slightly from this plan and building up our savings a bit further.

Now this all obviously ignores the fact that we’ll eventually have to pay taxes when withdrawing from our tax deferred accounts in retirement. We don’t anticipate earning in retirement what we are fortunate enough to make now. And while we can’t predict what tax rates will look like at that time, we’ll take the unknown and potential for a lower rate in retirement than the guaranteed high rate we’d have now.

But what if. . .

We understand this strategy isn’t for everyone, and it certainly isn’t a recommendation for anyone else. This is just what we’ve chosen to do. It’s why in the past three years while we’ve only paid off $130,000 in debt, our net worth has risen by $340,000 in the same time frame by also focusing on investing.

Making it a priority to invest is what we believe expedites our path to financial independence. We’re ok with that meaning it will take us longer to become debt free.

And if the stock market drops 30% tomorrow morning and falls further from there, we’ll still be comfortable with our decision. We’ll continue with this strategy since we’re looking out for what we think is best for our future rather than what’s best for today.



2 thoughts on “Prioritizing Debt vs. Investing

  1. Great job with the debt reduction to date and with your low student loan interest rates, I think your strategy makes great sense. I definitely wouldn’t recommend it to someone with high interest rate loans, but similar to you we don’t aggressively pay down our 3.5% mortgage as we usually do a blend of mortgage paydown and investing to optimize returns.

  2. Yeah, a mortgage is a good comparison. I think it comes down to both the cost of the debt (in terms of rate) and also whether you can handle the cash flow hit by making both contributions to investments and debt payments. Thanks for stopping by Chelsea!

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