I have noticed a trend involving wealth building that is all wrong. I see it in comments on other personal finance blogs a lot lately. I am sure it has been there all the while and it only jumped out at me recently for whatever reason. The misinformation is so important it needs clarification.
The comment goes something like this: I am not saving right now because I am paying off student loans/credit cards/car loans/making extra mortgage payments. When you pay down debt you ARE saving and also building your net worth. The real question is: How can you balance debt reduction with retirement savings for maximum net worth building?
Paying down debt removes the most caustic item on your balance sheet holding back wealth creation. Debt interest is an expense you can only slay by destroying the debt (paying it off). Debt is not a bad thing in and of itself when used as a tool, but most consumer debt is bad. Mortgages are the exception if used properly.
Let’s take some time to explore the best way to reduce debt and maximize return and net worth.
Pecking Order of Debt Reduction
We will address retirement savings in a moment; for now we will focus on debt only. My opinion is built on maximum return for each action you take which is different from other personal finance gurus like Dave Ramsey. Ramsey teaches you should pay the smallest debt balances first (snowball effect) so you reduce the number of bills quickly, giving you a mental boost. I was a Dave Ramsey Endorsed Local Provider (ELP) for years; I am very familiar with his teachings. My advice is slightly different.
I assume we are all adults and understand LESS debt (especially consumer debt) is better. You don’t need hand-holding or mental tricks to act like a responsible adult. You are here because you want to grow your financial understanding and increase your net worth.
The debt with the highest interest rate should be paid down first! Eliminating the highest interest debt does give a psychological boost as interest is reduced at the fastest rate. It also allows for faster net worth accumulation.
Debt payoff IS saving! Think of it this way. Example: You have several loans and a mortgage with payments of $2,000 per month of which $1,600 is interest. Making the minimum payment will increase your net worth $400. Do you get it? You made $2,000 in payments which included $1,600 of interest and $400 loan principle. The $400 reduces your balance, thereby increasing your net worth. Any extra payment will all go to paying down the debt eliminating interest on that part of the liability forever.
Debt Reduction Master Plan
There are a few steps (Ramsey calls them baby steps) to maximize debt reduction.
- Emergency fund: I don’t have an emergency fund. Most people with any amount of net worth generally don’t either. If you are saddled with debt you will need a small emergency fund of $1,000 to $5,000 until you have the resources to handle small emergencies. I don’t want you reducing debt and have a setback that causes more harm than good. A furnace or roof forcing you to take out high interest loans undoes all the hard work you have done reducing debt. Most people can get by with a $1,000 emergency fund. Once you have the financial ability to raise $1,000 or so quickly to handle emergencies the emergency fund is no longer a requirement.
- Order of Debt Reduction: The only way to guide a boat is with a plan. Gather all your bills and debt together and assess the situation. Now you can find ways to reduce spending and funnel the money toward extra payments on debt. Start with the highest interest rate consumer debt and apply the extra payments there. Large balances should be reviewed for refinancing. Eighteen percent credit cards and high interest auto loans and student loans require special attention.
The process is simple in theory, hard in practice. Debt builds easy for too many people. Living within your means and funneling the extra money first to debt reduction and later to investments is a radical shift requiring new habits. Cut spending to the bone. Every extra dollar reduces debt faster.
Track your debt reduction on a spreadsheet. Each month you should see the interest expense declining. From our example above, if your interest is $1,600 this month, the $400 principle payment and any additional payment applied to the balance will reduce the interest expense going forward. Next month your interest will be less, let’s say $1,580. Now you reduce your debt this month $420 just with the minimum payment. Staying on course does not mean paying small credit card balances first to get a psychological boost. The mental boost comes from seeing the interest assessed each month drop like a rock.
Debt is a crisis as serious as a heart attack. The trick is to eliminate debt as fast as possible without making the problem worse. The balancing act comes from taxes and retirement plans.
I know the desire is to fund a 401(k) up to the matching level regardless your debt level. I feel the same, but also know if your debt is high, funding anything other than debt reduction risks toppling the house of cards. When debt is maxed out you need to regain control of your finances first to bring you back from the edge. Once you have a small emergency fund and the most egregious debt well on its way to debt Hades you can consider balancing debt reduction with investing.
Just like paying off the highest interest rate debt first is a priority, you now need to bring investment returns into the equation. In this instance we only consider guaranteed rates of return. The stock market has excellent long-term returns, but they are not guaranteed. Employer retirement plan matching is one area of guaranteed high return. Investing into your employer’s retirement plan to the matching level provides two benefits: a high instant return on your investment (100% if funds are matched dollar for dollar) and a tax break. (In this post I will assume retirement investments are the deductible kind. The discussion between traditional and Roth retirement plans are left for another day.)
In the United States the tax code is stacked against spenders. The government taxes the shit out of you when you spend (income tax, sales tax, excise tax, gas tax, et cetera). What Congress has a hard time doing is taxing savers. To appease the masses Congress created several tax advantages for savers. The cost is minimal to government collections because most people are stupid and spend all their money and then borrow some more. You are not one of those people.
Savers pay a significantly reduced tax bill. We will focus on two benefits today: the Savers Credit and deductions. The Savers Credit applies to the first $2,000 net investment to retirement plans. Distributions from retirement plans affect the Savers Credit negatively so leave your fingers off the retirement stash. The Savers Credit is up to $1,000 per year. You never pay it back. The extra tax savings can be used to increase retirement investments. Unfortunately the Savers Credit is limited to relatively low income taxpayers. For example, the credit for joint filers phases out at $61,000. The Savers Credit is generally smaller for most people, around $200. Still, $200 is a nice additional benefit for investing in your future.
Traditional retirement plans (IRAs, 401(k), and similar employer plans) are tax deferred. Your contributions to the plan are not included in income until distribution. If your tax bracket is 25% and your employer matches dollar for dollar, your first year return prior to any investment gain is 125%. (I am aware I am playing fast and loose with the math. The goal is to show the return is large.) While you are in debt reduction mode you still want to take advantage of such generous opportunities whenever possible.
Putting It All Together
Let’s take a look at what we learned and put it into order for easier use:
- Assess Your Situation: Create an honest personal balance sheet, including all assets and debts. Now you have your net worth and all debts owed on one understandable page. Next, create an income statement from the household income and expenses. The income statement should help in determining where expenses can be reduced and applied to debt reduction.
- Assess the Debt: Debt should have a separate page to assess debt balances and a payoff strategy. List the debt with the balance and interest rate. Start with the highest interest rate debt and apply additional payments to this liability until it is laid to rest. Then move on to the next victim.
- Emergency Fund: Build a small emergency fund if your debt situation is excessive. You don’t want a flat tire to sink you right back into high interest debt.
- Prioritize Debt Reduction and Retirement Planning: Once you are away from the precipice it is time to maximize net worth building. Employer retirement plans with matching will provide a greater return on investment than the interest you are paying in most cases. Participating in an employer’s retirement plan to the matching level is an intelligent financial move. Don’t lose sight of debt reduction. The goal is to reach the highest net worth without risk. Debt reduction is a guaranteed return. Debt paid off does not accrue additional interest expenses. Once debt is eliminated you will max out all retirement accounts for the largest tax savings.
- Good Debt, Bad Debt: In my opinion consumer debt is bad. Car loans and credit card balances are caustic to financial health. (We leave credit card bonuses for another post.) Mortgages are different. We never get a loan because the interest is deductible, ever! Mortgages, however, are generally lower interest loans and will be one of the last things you pay off. Mortgages can be a powerful financial planning tool when used correctly.
- Mortgages: When consumer loans (auto, credit cards, et cetera) are eliminated it is now time to plan the assassination of the mortgage. I have a small mortgage and plan on killing it over the next two years even though it is not a net worth maximizing strategy. I started with a $300,000 death pledge and decided to plan its murder. I chopped it to under $130,000 this year with the final assault killing the darn thing over the next year or two. It hurts when I do this. The interest rate on my mortgage is 2.375%. Any other investment would have a better return than the mortgage cost. However, there is something to be said about living debt-free. Once your net worth is well on its way it is not always about maximizing the results. Debt spikes returns when things are increasing in price, but also causes downward spikes when things are not all roses. Debt-free is good even when it is not the best financial move. It is the best ‘sleep at night’ move.
- Time for Rocket Man: Once debt is history in your life you will have massive amounts of money to invest in retirement plans and index funds. Your skills acquired while reducing debt are still in play. While you reduced debt you learned how to cut costs, increase income, live within your means, and still remain happy with life. Without debt it takes almost nothing to live. Debt is what makes it so hard to make ends meet; the ends are rather close without debt payments. Now, interest is turned on its head. Instead of paying interest you are earning a return on your investments. What a concept!
There is no better feeling than waking in the morning, taking a deep sniff, and knowing you already made $722, more than you will spend in a week. A modest nest egg with no debt will generate a nice income stream to cover your lifestyle. Interest income, dividends, rents, and business profits all add to the mix. Like I said, the plan is simple in theory, difficult in practice. The sooner you start, the sooner you reach your goal, regain your sanity, and start living life the way you were meant to.