Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
If you suddenly had an extra $100 a week available to save/invest or use for debt repayment, what would you do? Set the money aside or increase your monthly debt payments? The question of which comes first - saving/investing or debt repayment - is one that financial educators and advisors frequently receive from people who are trying to set financial priorities.
Essentially, this is a classic “opportunity cost” question. Opportunity cost is officially defined as “the value of the next best alternative that must be foregone when you make a decision.” In layman’s terms, you can think of opportunity cost as the things that you give you up when you decide to do one thing instead of others. Which brings us back to our original question...is it better to save $100, add it to “regular” debt repayments, or even do a little of both? Obviously, if you choose to do one thing completely (i.e., save the entire $100), you cannot do the other (i.e., add the $100 to outstanding debt balances).
So what should you do? The best answer to this question is probably one that is used in many financial planning decisions...”it depends.” In other words, there is no automatic “right” answer that would apply to everyone all of the time. Choices need to be made based on personal circumstances and available saving/investing options.
Many people would argue that debt repayment should take top priority. After all, interest rates charged for many types of debt (e.g., credit cards) are often in the double digits compared to relatively low rates of return earned on cash equivalent assets such as bank accounts and money market funds. It is often said that paying off high-interest credit cards is equivalent to earning whatever rate is charged on the card (e.g., 18%). Actually, paying off debt has an even higher equivalent investment return when you consider that income taxes must be paid on investment returns.
If you decide to save the extra $100, you must earn a higher before-tax dollar return on investments than the after-tax return that is equivalent to the rate of interest charged by a credit card. Here’s a simple example. Paying off an 18% interest credit card is equivalent to earning about a 21% investment return for someone in the 15% marginal tax bracket (see http://njaes.rutgers.edu/money/taxinfo/ for a list of federal income tax brackets according to tax filing status and taxable income). Here’s the “equivalent interest” calculation shown mathematically: 21.2% x .15 = 3.18 and 21.2 - 3.18 = 18.02.
For someone in the 28% marginal tax bracket, paying off an 18% interest credit card is equivalent to an even higher investment return of 25%. Again, here’s the “equivalent interest” calculation shown mathematically: 25% x .28 = 7.00 and 25 - 7 = 18. The higher a person’s marginal tax bracket, the more of an “investment” debt repayment becomes, because he or she must earn a higher rate of return to compensate for higher tax payments. This is just one reason why the correct answer to the “save or reduce debt” question is “it depends.”
If a comparison is made between debt repayment and savings placed in a tax-deferred 401(k) or 403(b) retirement savings plan with employer matching, then the mathematical calculation gets a bit more complicated. In this situation, many financial advisors would favor the saving/investing option with at least part of the available money, because the match is essentially “free money” that should not be forgone. In addition, an employer match of 50 cents for every dollar that employees save is essentially a guaranteed 50% investment return, which trumps even the highest interest rates charged on credit cards. There is absolutely no other investment available that can guarantee a 50% return.
Another option for the extra $100 could be to use it to prepay the principal on your mortgage, thereby saving debt repayment time and future interest charges. Here, the key comparison will be between the interest rate charged on the mortgage (after-taxes, if you itemize mortgage interest as part of your tax deductions) and the rate of return that could be earned elsewhere, such as on stocks or growth mutual funds. Of course, repayment of higher interest debt (e.g., credit cards) would almost always trump principal prepayment on a mortgage or home equity loan, as well as non-retirement plan investments, due to the much higher interest rates that are generally charged.
A person’s tolerance for investment risk would also be a key decision-making factor when deciding between prepaying a mortgage or purchasing different types of securities. If you are a very conservative investor who shuns the stock market completely, your mortgage interest rate may well be higher than interest rates available on cash equivalent assets. In this case, debt repayment may be preferable to saving.
Now let’s assume that the available $100 would be used for emergency fund savings, instead of mortgage principal prepayment or a retirement savings plan. Perhaps, right now, you don’t have much (or any) money set aside for an unexpected expense or a financial crisis such as unemployment. In this situation, mathematical calculations and interest rate comparisons will not be the deciding factor between saving and debt repayment. The key point here is that you need a cash cushion, even if you will not be earning a high return on this money.
Everyone needs to have some cash reserves so that, if an emergency occurs, they have money available. This way, you will not need to use a credit card to handle a financial crisis, which simply adds to your existing debt load. Financial experts often recommend setting aside three to six months of expenses as an emergency reserve, which can seem like an impossibly large sum if you’ve had difficulty saving in the past. Remember, though, that any savings is better than no savings at all. Save as much as you can and gradually work up to an amount equal to three months expenses. Once your outstanding debt is repaid, you’ll have even more money available to save. If you decide to put money in a retirement savings plan instead of an emergency fund, there are options to borrow or withdraw this money in an emergency.
Still can’t decide what to do? Here’s another thought. The answer to the “save or reduce debt” question does not have to be an “all or nothing” decision. A third strategy is to do a little of both; i.e., use the extra $100 to save and reduce debt. Determine a formula that seems reasonable to you and stick with it. For example, since credit card interest is generally much higher than interest rates earned on cash assets (such as a money market fund), you might decide to spend $75 on debt repayment and save the remaining $25.
By saving money and reducing debt at the same time, you’ll still be making a dent in your outstanding debt. You’ll also be building up some cash reserves and/or taking advantage of compound interest on long-term savings (e.g., 401(k) plan deductions from your paycheck). Perhaps even more importantly, though, you’ll get into a regular savings habit now instead of waiting until all of your debt is completely repaid, which could take years. Some people may prefer a 50/50 approach; i.e., saving half of their available cash and earmarking the other half for debt repayment.
So what comes first: saving/investing or debt reduction? It depends.
