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March 30, 2011

3

Savings vs. Debt Reduction. By the Numbers

Hey guys, how’s it goin’?

In my last post, I talked about what you have to do to get out from under credit card debt.  It can take a long time to do and you may be raring to start growing your savings.  Today I want to talk about the age-old question, “Is it smarter to pay off my bills before saving or investing?”

In general, you will end up making more by paying off your debts before saving.  Shoveling every spare dime into retiring your debt will free up more money faster.  Allow me to illustrate:

Assumptions:

  • A $50,000.00 loan, compounded monthly at 8.5% over 10 years.
  • An annualized return on investment of 4.5% compounded quarterly.

I used Excel to calculate a payment of $619.93/month and set up an amortization schedule.  I’ll show you three scenarios.

Scenario 1:  Pay off the loan per the amortization schedule and invest $100/month.

  • Loan paid off on schedule (120 payments)
  • Total Interest Paid on the Loan = $24,391.41
  • Total Return on Investment = $2,299.24
  • Net Interest Paid = $22,092.17

Scenario 2:  Pay off the loan plus $100.  When the loan is retired, invest the total payment amount for the balance of the term ($719.93)

  • Loan paid off two years early (96 payments)
  • Total interest paid on the loan = $19,064.32
  • Total return on investment = $642.95
  • Net Interest Paid = $18,421.37

Scenario 3:  Pay off the loan plus $50 and invest $50 per month.  When the loan is paid off, invest the total payment amount for the balance of the term ($719.93)

  • Loan paid off 14 months early (106 payments)
  • Total interest paid on loan = $21,389.62
  • Total return on investment = $1,023.45
  • Net Interest Paid = $20,366.17   (*edited to remove rogue minus sign)

The best strategy is to retire your debt as quickly as possible as long as you keep saving and investing the money after the debt is paid off.

Caveats:

  • If you don’t have an emergency fund, you’ll have to sacrifice those possible gains to build one.  An emergency fund is a crucial component of paying off your debt.  If you don’t have the cushion of an emergency fund to fall back on, you’ll just be forced to go back into debt when your car breaks down or your roof has a leak.  If I’ve said it once, I’ve said it a thousand times.  There are few things more frustrating and demotivational as taking one step forward and then two steps back.  While you can still pay off extra, you should be putting some money in an emergency fund at the same time.
  • If the interest on your debt is significantly less than what you would reasonably expect to get from investments, then use the money to invest.  For instance, the interest on my student loan payment is less than 4%.  My investments are returning around 5%.  Of course, that’s after years of reading and studying value investing before I invested my first dollar.  And I could easily lose money next year.  It’s not easy to maintain good returns year after year and it’s best you don’t try until you’ve read up on the subject extensively.  This is a very risky strategy if you know what you’re doing.  If you don’t, it borders on disastrous.

Hope you found this post useful.

Until next time, keep on saving!

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