Should I focus on investing or paying off debt?
At Windward, we like to see people debt-free but they also need enough retirement savings to last them throughout retirement. So debt-free or retirement savings? The answer is unique for everyone, but there are some basics to consider.
One way to analyze the question is to compare the money you may be earning on your savings (like investments) versus the interest cost on your debt. If you think you will earn less on your investments than you would spend on your debt interest, then paying off the debt may be the better answer. For example, you may have a mortgage that charges 4% interest while your money market account is earning 1%. In this example, it would be more advantageous to pay off the higher interest rate on the debt than trying to earn the 1% from the interest earned by the savings account. We suggest doing this analysis on an “after-tax” basis. That is, some interest expense is deductible and some investment income is taxable. To get an apples to apples comparision, reduce your interest expense by expected tax savings and reduce your investment income by expected tax cost.
A second way to do the analysis is to retire debt ASAP and then focus on saving. A good approach is the snowball method: Temporarily stop savng and then snowball your debt payments one by one until the debt is retired. Then resume snowballing those payments in to savings. This method has the advantage of focusing on one financial goal at a time. Prioritize your total debt balances from smallest to largest. Retire the smallest balance as quickly as you can, and pay minimums on the other debt payments. Once the smallest balance is retired, pay off the next smallest balance. You are “snowballing” your payments by focusing on one debt at a time, tackling the next debt and adding the minimum you were paying on top of that, and so on and so on. Once your debt is paid off, you will have a the cash flow to add to your savings. Now you can focus solely on saving and saving larger amounts than you were when you had the debt payments!
Here is a simplified example of snowballing payments:
Debt balance #1: $1,500 Minimum payment: $50
Debt balance #2: $5,000 Minimum payment: $100
“Snowball amount” refers to the extra money available each month to save or go towards debt
|Date||Snowball amount||Minimum pmt #1||Minimum pmt #2||Savings
|Debt Balance #1||Debt Balance #2|
In this example, in just nine months this person has retired $6,500 in debt and saved $3,850 using the snowball method!
No matter which method you use, we recommend that you have an adequate cash reserve before your start. Otherwise, you are likely to go right back into debt.
This blog is provided by Windward Private Wealth Management Inc. (“Windward” or the “Firm”) for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. No portion of this blog is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in the individual blog posts will be derived from sources that Windward believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.
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