Paying Off Debt Vs Investing: The Millennial and Baby Boom Dilemma
At some point, everyone is faced with the question of whether they should pay off debt or invest with “excess” cash.
No matter where you are on your life journey, whether you’re a Baby Boomer or a Millennial, it is crucial to know how you should use your money to ensure that you’re making smart financial decisions.
Paying Off Debt Vs Investing
Young earners and those approaching retirement seem at first glance to have very different financial motivators and requirements.
Those nearing retirement ages want to ensure that they’ve got a nest egg built, and a way to earn a passive income throughout their “golden years.”
Younger earners are already piled high with debt and have more coming in the future, in the form of house payments, weddings, college educations for their children and the like.
Paying Off Debt Vs Investing: The Case for Baby Boomers
One would-be investor asks, “I’m getting close to retirement age, and I’m still making payments on my home loan. I’ve also got money out in the form of financial help to my kids for school with my name on it. Should I be investing for retirement and using the interest to pay my debts, or paying off the debts I currently have before investing?”
The answer to the question of paying off debt vs investing posed above might surprise some people. You would assume that planning for retirement is the single most important thing for anyone approaching that big day.
However, here’s the deal. If you have existing debt, and you’ll be carrying that over into your retirement, it will eat into your nest egg. Just because you reach retirement age, it doesn’t mean that your debts evaporate. However, a significant portion of your income will, which can make repaying your debt incredibly difficult.
The best advice for Baby Boomers is to focus on paying off debt.
Your goal is to protect capital, and in a current rate environment, it is almost impossible to have a risk-free return that is greater than the interest you’re paying on credit card debt or your mortgage.
By paying off debt before investing, you reduce the pressure to make big returns, protect your capital, and better position yourself for your retirement years.
Paying Off Debt Vs Investing: The Case for Millennials
A Millennial asked, “I’ve got a lot of student debt, but some extra cash in my bank account. Should I use that money to pay down my student loan debt, or should I invest it and use the returns to offset my debt?”
Again, it seems like the right answer would be to invest and use your returns to pay your school loans, but that’s not always the case.
If your employer offers dollar-to-dollar contribution matching in your 401(k) plan, for instance, up to 6% of your annual salary, it’s an excellent idea to take advantage of the offer. By investing $6,000 into your 401(k) over the course of a year, you also earn the same amount from your employer, giving you $12,000. It’s a 100% return on your investment.
Think of it as free money, and the return certainly trumps anything you might find in the financial marks.
Once your potential 401(k) contributions have been completely used, you’ll need to focus on paying down your high-cost debt. For instance, if you’re carrying 7% in student debt, but you also have 18% on your credit card debt, you’d want to pay off your credit cards first, and then focus on your student debt.
Finally, you’ll need to get those student loans paid off before you start investing in anything.
The reason for this is the very good chance that the interest rate on your student loans will rise. As they increase (and the Fed has made no bones about jacking up rates very soon), your debt load actually increases, as does the time needed to repay them.
You will need to make larger and larger payments in order to keep your head above water. There is simply no way that the returns on your investment will enable you to live without this affecting your financial situation.
The Prospect of Higher Returns Debunked
Yes, there’s a lot to be gained if you can make smart investment decisions and garner big returns. If your returns are more than the interest you’re paying on your debt, then investment might be the right decision, rather than paying off debt.
However, this is virtually impossible to achieve without playing the stock market.
While stocks can be valuable investment options, there is no such thing as a guaranteed return. The risk is the name of the game, and all too often, investors find that their decision not only fails but that their investment capital is lost along the way, leaving them in a worse financial situation than before they invested.
Compound that with the fact that your mortgage payment or student loan payment will still be due, and that you’ll be facing rate increases as well, and you can see just how risky this situation actually is, as Jason Heath points out in his article for the Financial Post.
In addition, any future return of the stock market is going to be low and slow. In their most recent research, McKinsey stated that the stock market return for the next 20 years is an abysmal 4% to 6.5%.
Definitely, think long and hard before using any loaned money to make an investment.
Your Situation Is Unique
With the information above in mind, it is also important to realize that everyone’s situation is unique. What’s right for you will not be right for someone else. You must ensure that you’re planning for your own future, and that means doing a little bit of legwork.
One important thing to do before making any investment or debt repayment decision is to compare your after-tax return on an investment and your after-tax return on debt repayment.
The numbers don’t lie – which option leaves you in the black (or closer to the black), and which one is smeared in red?
In most instances, paying off debt before investing is the right decision. It allows you to free up your capital, and in the case of Baby Boomers, protect that capital. Without further drains on your finances, you have greater freedom to invest, with less pressure to take serious risks with your money.