Hi. I’m Matt Sczurek, and today I want to talk about debt, and whether it makes more sense to make minimum payments on your debt while still contributing to your investment accounts, or to use the cash flow from the investment contributions and pay aggressively on your debt. Ultimately, this decision will be influenced by several different factors, and there is no quick answer for every situation. Therefore, this video should not be taken as advice. If you would like some help interpreting your own financial situation, please give one of our advisors a call and we would be happy to give you some direction.
When dealing with debt, it’s important to understand what type of debt that you have, the amount of debt that you have, and the interest rates that you’re paying. As a rule of thumb, it’s good to keep your total monthly debt payments below 36% of your gross monthly income, your total housing costs below 28% of your gross monthly income, and your total consumer debt (or non-mortgage debt) below 20% of your net monthly income. This may not be a reality for everyone, but it might be a good goal for anyone who isn’t there yet.
Concerning interest rates, it would be optimal to focus on paying higher interest rate debt first. For example, if you have outstanding credit card debt that’s charging a rate of 18.99%, you will better utilize your free cash flow by paying this amount down before paying off a personal loan at 5 or 6%. This logic would also follow that you would better optimize your cash flow by paying higher interest rate debt before making contributions to an investment account where the expected return is lower since an average investor would not reasonably expect an average long-term return of 18.99%. And I would agree in some situations, however I’m going to show you an example of why it doesn’t make sense to forgo making investment contributions entirely.
Let’s say we have 2 people who just celebrated their 25th birthdays. They can each expect an average long-term return on their investments of 8% which will compound monthly for the purpose of the example. Person A decides to contribute $100 per month into their investment for a period of 10 years and then stops. On their 35th birthday, they will have contributed a total of $12,000, and their account balance will be $18,294. Assuming they leave the account alone, it will grow to $200,065 by age 65.
Person B on the other hand does not make any contributions for the first 10 years. Beginning on their 35th birthday, they contribute $100 per month to their investments for the next 30 years. On their 65th birthday, they would have made total contributions of $36,000 and the account would be worth $149,036. This example shows the value of time, and how making contributions early can lead to greater growth over time.
A good debt repayment strategy will weigh the value of both paying down debt and making investment contributions, and balances them to help you best achieve your goals. But the most important thing is to form a plan and stick to it. If possible, make your payments and investment contributions automatic so that you don’t have to decide each month on either. Again, if you have questions or would like us to help analyze your situation, reach out to our advisors and we will help set you on the right path. Thank you.