My Wife And I Debate Over Investing Or Paying Off Debt

About a week ago, I mentioned my investment plans now that we have a house. This post happened to be at the top of the site when my wife visited it, and it spurred a week long discussion between the two of us on whether we should be focused on building up that investment or focused on paying off all of our debts first, potentially freeing one of us to be a stay at home parent (a definite possibility for at least a few years in the future, especially if we have more than two children).

We currently have three student loans and our house debt outstanding, with the highest debt being a student loan at slightly above 7%. All of these loans are locked in permanently at their current rate. We carry no credit card debt, own both of our vehicles, and have some significant savings towards our next vehicle purchase.

Essentially, we have to be able to beat a 7% return on our investment to put us money ahead with the investments, but that’s over the long term. If we invest now and decide to have one parent move to a stay at home situation, we’ll want the money sooner rather than later, and we both have bad feelings about many investments over the next few years.

Stocks are a great investment over the long term, but over the short term they can be incredibly risky. If you put some money in the stock market today, I’ll bet you anything that you’ll have a gain ten years from now, but I certainly wouldn’t make the same bet over just the next year.

So we’ve mutually decided to put the investment plans on hold and instead pay off our debts for the time being. We look at it this way: it’s a 7% return on our investment, period, both in the short term and in the long term. We’ll start with our highest interest loan and use the savings account method of paying it off: put the money we’re going to use to pay it off early in a savings account and use it as an emergency fund until it’s well past the value of the loan, then pay it off with one check.

Of course, this may be reevaluated in a few years when it’s clear whether or not a stay-at-home situation is best. If we decide that it’s not, then we’ll perhaps look more seriously at investing. Until then, we’ll focus on paying off those debts.

I’m still going to tinker with investment ideas on here – my goal is to seek out the best possible plan for when we do delve into investing. For right now, though, paying off our debts looks like the best road for us and we’re going to go down that road with our usual gusto.

What’s the lesson here? A person or a family may have an individual situation that makes their best financial route different than the financial route others might take. For example, if we were not thinking at all about having one of us be a stay-at-home parent, we might go for the investment route because we’d be far more interested in long-term gains that could easily exceed 7% a year.

In the end, this is a perfect example of the importance of specifying goals right off the bat. When we sat down and talked about our goals, we realized that eliminating our debts looked like the best route for us. If I stuck with my initial investment plan, we may have been making moves that didn’t match the goals we had as a couple – and thus we could have been stuck out in the rain.

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  1. paidtwice says:

    I’d be interested in hearing the benefits of doing the “savings” account method of paying off the student loan vs paying extra towards principal every month. I’ll soon be starting to aggressively focus on paying back my (and my spouse’s) student loans and I’m interested in benefits of different repayment methods and why people choose them.

  2. Ryan says:

    Great post. My wife and I had this same conversation when we got our tax return this year. We decided to put it toward paying off debt. I’m the type of personality that pays a “psychological” interest rate when it comes to debt. It’s an incredible weight off my mind to have this paid off and I think this is an often over-looked benefit.

  3. plonkee says:

    Looks like you’ve made a good choice for you.

  4. Jim Knudsen says:

    Choosing to invest or to pay off debt seems to be a very personal choice and I wouldn’t say that it is the wrong one. However, I would urge you not to put investing on hold entirely. If you can start, even to a smaller degree than you originally planned, you are not giving up your opportunity to have decades of compounding.
    I looked at the investment choices in your earlier column. You might be able to attain your portfolio goals with Vanguard’s Lifestrategy-Growth fund. It is made up of some of the funds you were originally looking at. It is similar to the Target Retirment fund, except the asset allocation remains the same as time passes rather than becoming more conservative. With this fund you could get your desired diversity as soon as you had the first $3000.

  5. As advantageous as it is to start investing early, you might want to consider doing both at the same time.

    We all know the story of the twin brothers. One started investing at age 22 and put in $2000 a year for 6 years. The other brother didn’t start until the 7th year and he put in $2000 for the next 37 years. With the same return, at the age of 65 their investments are worth the same amount. Even though the 1st brother only invested $12,000 while the second brother invested $74,000. Waiting can be pretty costly.

    And, at least for me, watching investments increase is more motivating than watching debts decrease.

  6. MillionDollarJourney.com says:

    Trent, remember that the 7% return that you’re comparing to is an AFTER TAX return. So, if you invested in a taxable account, you would need a 10%+ to achieve the same results. Perhaps you can maximize your 401k, and use the tax return and any extra savings you might have to pay down your student loan debt.

    Question, is your student loan debt tax deductible?

  7. Adam says:

    There’s also something to be said for the “investment” in keeping each other happy. My wife and I have had similar discussions as our debt has gone way down, but I know she will be much happier with the debt gone. Then she won’t have any problem investing for our future and our kids’ college funds (the oldest is less than 2, so we have a little while…emphasis on “little”).

    Keep up the great work!

  8. Brian says:

    Tax deductibility (sp?) definitely makes the answer a lot more complicated. Depending on the amount of student loan interest you can deduct at tax time, your effective rate could be only 5 or 6% (instead of the 7%).

    To be honest, though, I don’t think the “savings account” method will make much difference in total return, but it gives you the ability to deal with any emergencies that may happen in the future. Once you throw money at installment debt, you have to find other, sometimes more expensive, debt to replace it.

  9. Becareful about what odds you give on 10 year bet – if you are giving odds. Japan has had slumps for 10+ years. I think they’ve even had slumps for as long as 20 years.

    MDJ makes a great point of considering the tax difference. However, since long-term capital gain can be 15%, I’m not sure you’d have to make the 10%+ that he mentions. It may be closer to 8.5% – still quite do-able.

  10. Phil says:

    Trent,

    I respectfully disagree with your decision to forgo investments in favor of paying down tax-advantaged and relatively low interest debt.

    In your particular situation (it appears that you are already maximizing your retirement plan contributions) you suffer no grievous damage by your choice. However, most Americans have a tendency to pay down debt prior to funding tax advantaged accounts…which by admission of the Fed is a mistake. I agree that you have to take into account your individual circumstances, but look at both sides of the issue.

    Here are three resources that may be helpful.

    http://www.cmpsinstitute.org/images/HowtoSafelyManageHomeEquity.pdf
    http://www.finra.org/PressRoom/NewsReleases/2004NewsReleases/P012717
    http://www.chicagofed.org/publications/workingpapers/wp2006_05.pdf

  11. MillionDollarJourney.com says:

    Yes, Lazy, I was speaking from the Canadian perspective, OOPS! :)

  12. dclounger says:

    Re: debt payment plan & taxes. I would recommend paying off the debt with increased monthly payments rather than letting they money build in a bank account somewhere. Of course, the point about building up an emergency fund is completely valid and allows you to have options with that money down the line (which is worth something), but from a pure “rate” standpoint, you’re better off paying gradually:

    Let’s say you put the money in a money market at 5% and your tax bracket is 25%. The interest is taxed at ordinary income rates, so that return is really 5% x (100%-25%) = 3.75%, meaning the “cost” of paying off the debt this way is 7% – 3.75% = 3.25%. In fact, if you look at it in reverse, paying off the debt is equivalent to finding either a 9.33% money market fund (9.33% x (100%-25%) = 7%) or a 15%-tax-rate capital gains investment returning 8.23% (8.23% x (100%-85%) = 7%), because that is the return that you’ll need to pay taxes on your gains while covering the accuring interest as you are waiting to pay off the debt.

  13. Christine says:

    Could you explain the Savings Account Method. Or if you already have, where can I find that in your blog?

  14. Jessica says:

    I’m just a bit confused on the kid front. I thought you had two kids plus one on the way. Hmm?

  15. Amanda says:

    All of the larger economic indicators indicate that we’re about to go into a recession that’ll make the 70s look like a cakewalk. I think paying down your debts is a great thing to start doing – stocks are going to take a nosedive once the Fed starts lowering the interest rate to counter stagnation.

  16. Trina says:

    I strongly agree with your decision to pay off your debts before funding investments. Loan payments are required every month, savings are optional. Savings are very important, but you’ll never be hounded by a collection agency telling you to pay your savings bill. Paying off debt gives you options.

    The option to stay home with your children is highly valuable – that’s what I’ve done, so I’m completely biased. But I know that kids will value the time spent with their parents more than any college fund. Having a parent at home adds a quality to life for the whole family and I think it’s well worth the financial sacrifice. Plus, there are numerous ways to be creatively thrifty.

    I would not worry about paying down a mortgage, though, at this point in your life. I’d keep extra money in your savings account, especially with a growing family. Once again, this gives you options.

  17. daria says:

    I agree with needing more information about the savings accounts method. It seems like that’s the worst of all worlds: earning a small return and not stopping the interest from accruing either.

  18. Margaret says:

    I believe the point of saving in a savings account and then paying the debt in a large chunk is that it is psychologically more satisfying to pay it off at once than to just send dribs and drabs of extra money at it for months on end. Also, the funds are there in case of emergency. I personally think I would have too hard of a time not spending that large amount of accumulating cash instead of saving it for the debt. I am better off putting the money against debt as I have it available.

  19. Vicki says:

    Consolidate somewhere else!!! If the “snowflake” method works for you, find a company with half a brain that actually lets you pay down principal (my student loan lender, Citibank, has a box to check which asks if extra is to principal). Vote with your feet!

  20. Cabe says:

    Student loan interest is only deductible if your income is under $50-65K (~100-130 for married joint filers). So it does seem like the 7% bar needs to be higher. Thanks for posting your cogent thoughts; I had long been thinking I only needed a 6.5% savings account to beat a 6% loan rate and now I realize I’ve been losing money (since of the 6.5% I am only getting ~4.75% of it).

  21. It’s good that you worked through this as a couple, as not everyone does. The key thing is to have agreed aims and being clear about what you want right from the start, which is what you seem to do anyway trent.

  22. Catelyn says:

    I will be graduating undergrad in Dec 2008…with the crash course economy I am looking at creative ways to start paying my stafford loans. I am currently working at a cafe only…and have an undetermined future in the job market. I have become interested in sustanible living and not persuing any other large finances until I have some reasonable funding. I currently live for free at my internship and use the cafe/healthfood store for my food. I am wondering if there is someone who has gone through paying the student loans

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