This is a series intended to answer the question “I’m covering my bills, now what?” It’s for people who have a steady source of income and have a vague notion that they should be doing something more with their money, but don’t really know how to begin. This will go through what to do with that money post-bills, from setting up an emergency fund, to debt management, retirement, and investment. Although most of this information is applicable to civilians, we’ll also be providing resources and information specifically geared toward military servicemembers and their families.
Last week we discussed why building an emergency fund is your first priority. Once that’s been accomplished, your next step is to pay off your debt. This is especially important in the military world as too much debt can affect your ability to get security clearances.
Many financial people separate debt into “bad debt” and “good debt”. I prefer “bad debt” and “not-so-bad” debt. Here’s a definition of those categories:
- Credit card debt
- Pay day loan or paycheck advance
- Student loans, depending on the interest rate
- Anything over a 7% interest rate
- Subsidized student loans
- Mortgage (Note: Mortgages are a little unusual. We have a post planned for more details about this later down the road)
- Anything under a 5% interest rate
Let’s talk about that 5% interest rate. Later in this series I will discuss investing in index funds aligned with the S&P 500 which average a return of about 7% adjusted for inflation since its inception and over a long period of time. (Source) I would argue that any debt with an interest rate greater than 7% you most likely won’t earn on your own, so it’s in your best interest to pay off that debt as quickly as possible.
On the other hand, if a debt has an interest rate of less than 5%, you are better off making the minimum payments and investing the remaining money. As I explained above, the S&P 500 will historically give you a return of 7%. But I like to err on the conservative side and assume I will make less than that, which is why I’m rounding down to 5% in making this rule. You can make more by keeping the money and making the payments than you would save by making a lump sum payment toward said debt.
Let’s say for example that you have a subsidized student loan of $10,000 with a low interest rate of 4.3%. You get a windfall of money; $10,000, to be exact. And since you already have an emergency fund established, you are trying to decide if you should put more money toward paying off the student loan, or if you should invest that money in the S&P 500 as I described above.
If you pay off that loan outright, you save yourself $430 of interest. Not bad. But you can earn $700 if you invest that money and are able to earn 7%. This means that after subtracting the extra interest you would pay on the student loan, you would still be up $270. Now to be fair, I did state that the S&P 500 averages 7% in the long term, and anytime you invest in stock you take the risk of it not performing as well as you expected. However, we already established in this hypothetical scenario that you would have an emergency fund, so you should be able to let that money sit for the long term and, based on historical averages, it should return you 7% or more annually.
Even if the stock only returns at 5%, you would make $500. Again, after subtracting the extra interest you would pay on the student loan, you would be up $70. But then you reinvest that $500 that your stocks earned you, so you now have $10,500 earning interest. If it only returns 5% for another year, you gain $525 that second year. And so that cycles continues. We will discuss investing and the S&P 500 later in this series, so at this point don’t get too caught up in the details of the stock. For now, this example is intended to illustrate how investing money rather than paying off a not-so-bad debt of under 5% can increase your wealth.
Table: With your windfall of $10,000, should you pay off a student loan at 4.3% or invest the money?
|Option 1: Pay off loan||Option 2: Invest and earn 7%||Option 3: Invest and earn 5%|
|Amount earned first year from $10,000||$430 (saved in interest)||$700||$500|
|Amount earned minus interest on loan||$0||$270||$70|
Some argue that knowing for sure that you will have a guaranteed rate of interest that will be there month after month if you do not pay your bills down is worth tackling earlier than later to save money that would otherwise go towards carrying interest payments. Individuals using this school of thought may also mention that the market is volatile, and therefore while debt accrued by running interest is guaranteed, returns on stock market investments are not. There is truth to this. However, if you have your emergency fund established, you can afford to weather the storm and let your investments rise in the long term.
What about that blurred line if an interest rate is between 5%- 7%? At that point you just need to decide if you would rather have the money in your own hands in your investments or if you would feel more relieved having your debt paid off.
You can also use this calculator here to help you determine if you should pay down your debt or invest. The calculator works a bit differently than my example above in that it assumes an additional monthly payment, rather than a lump sum pay off. However, it still may be useful in helping you make an informed decision about your debt.
I want to speak briefly about mortgages, as they tend to be their own beast. As you can see above, I placed the mortgage payment under the category of not-so-bad debt. As you read on personal finance, most conventional wisdom doesn’t really count mortgage as debt per say, which is why I placed it in that category. Additionally, mortgages are typically under 5%, which is also why I categorized them in such a way. However a mortgage can prove to be a bit of a counter-example when it comes to carrying this debt or paying it off. In fact, when it comes to home mortgages as debt, there are many schools of thought about whether or not to pay off the debt as quickly as possible or to carry the debt and invest in other areas. What’s more, the experts don’t even agree, as you can read in this article here.The problem with a mortgage is the loan amount is so large. Let’s say for example that you have a mortgage of $400,000 and a 3.5% interest rate. You might think “Well, I can earn 7% investing, so I will just pay the minimum and invest any extra”. Let’s do some really simple and quick math to see if that’s the case. Well 3.5% of $400,000 is about $14,000 of interest for the first year (a little less, because you would be making payments, but stick with me here). If you can invest $500 a month, that’s only $6,000 a year principal, and if you can make that 7% off your investments that’s only a total of $6,420 (a little less actually, because that whole $6,000 wasn’t invested at the same time). I know these calculations are very rough, but they don’t need to be as there is such a huge difference between these two numbers- $14,000 vs $6,420.
Table: Pay down the mortgage or invest?
|Mortgage:$400,000||Yearly investment: $6,000|
|Amount accrued with interest||-$14,000||+$6,420|
These aren’t super accurate calculations because I’m just trying to make a quick point here- the mortgage is so large and has so much inertia that it’s hard to build a big enough side investment that makes more money than the mortgage accrues. The Finance Buff ran a much more accurate calculation on taking a 30 year loan and investing the difference that you can read about here. Although it’s a slightly different question that he’s answering, he shows how long it takes for investments to match a mortgage. Additionally, you can use this calculator to experiment with your own mortgage and see if you are better off paying down your mortgage or investing the difference. Mortgages are a big topic and we have many posts planned for a later date going more in depth about mortgage issues and we will do more accurate calculations at that time. But as this is a beginners’ series, I just want to touch on the idea of whether or not to pay down your mortgage or to carry that debt and provide some resources for my readers to explore those options.
If you are still unsure about what debts to pay off first, or if you should pay off the debt or invest, you can seek professional services. The National Foundation for Credit Counseling is a non-profit organization that provides debt counseling at little to no charge, depending on the services rendered.
For military families, there are many resources that aid in debt management and consolidation. The Servicemembers Civil Relief Act (SCRA) states that any debt accrued before military service is reduced to 6% for active duty servicemembers. This includes credit card debt as well. If you are interested in taking advantage of this lowered interest rate, talk to your local Judge Advocate office (find yours here). You can also find more information here about whether or not you qualify for student loan forgiveness or other similar financial programs for being active duty. For other questions about debt management for military families, you can also speak to a financial advisor for free at the Family Readiness Center.
Stay tuned for next week’s installment of the Getting Started Series, in which we will cover retirement accounts.