I am inundated with questions such as:
As a young physician who graduated last year, I'm trying to decide if I should prioritize completely paying off my very large student loan debt ($400k @ 4.5%) or if I should prioritize retirement even though the expected payoff might be less than 6%.
or
Is there any point to setting up a 529 for your kid if you aren’t maxing out your 401(k) yet?
Unless and until you are debt-free, you will always have the Invest Versus Pay Off Debt Dilemma. However, there is more to this conversation than I usually see discussed. The issue is really a question of weighing various priorities inside of a financial plan and then directing available cash flow toward those priorities in a way that ensures they are each reached at the appropriate time while taking advantage of all possible tax and investment benefits. Let's come up with a hypothetical investor and some hypothetical goals to illustrate the point.
Setting SMART Financial Goals
Let's say a 35-year-old physician investor earns $250K per year, owes $150K in student loans at 4.5%, has a $500K, 3.5% 30-year mortgage, has two children (2 and 4), and wants to retire someday. Perhaps she writes a financial plan that includes the following goals:
Pay off my student loans before age 40
Have $100,000 saved up for college by the time each kid turns 18
Pay off my mortgage by age 55
Retire at age 60 with $4 Million in today's dollars
With specific financial goals, one can work backward using reasonable assumptions to determine how much money must be put toward those goals each year to reach them on time. Let's take them one by one.
Calculations for Your Financial Goals
She has 5 years to pay off student loans. That's about $30K/year, plus interest. A simple spreadsheet calculation will tell her exactly how much she needs to put toward those financial goals to reach them.
=PMT(4.5%,5,-150000,0) = $34,169 per year for 5 years
She has 14 years for child # 1 to hit $100,000 in her 529. Same calculation, different numbers. We'll have to assume an investment return. Since 14 years is a long time, let's use “real” after-inflation numbers so you end up with $100,000 in today's dollars. Let's use 5% real. If you think that's too low or too high for your taste, you know how to adjust according to your crystal ball.
=PMT(5%,14,0,100000) = $5,102 per year for 14 years
She has 16 years for child # 2. We'll use the same assumptions.
=PMT(5%,16,0,100000) = $4,227 per year for 16 years
She has twenty years to pay off that 30-year mortgage. The regular payment on the mortgage (not counting insurance and taxes) is:
=PMT(3.5%,30,-500000,0) = $27,186 per year for 30 years.
In order to cut that down to 20 years, just change 30 to 20 in the calculation.
=PMT(3.5%,20,-500000,0) = $35,181 per year for 20 years
So she'll need to pay an extra $7,996 per year, or $666 per month to pay it off 10 years early.
She wants $4 Million for retirement in 25 years. Again, it's a long period of time so let's use a real 5%.
=PMT(5%,25,0,4000000) = $83,810 per year
Adding It All Up
If you look at any of those calculations individually, none of them seem terribly unreasonable, right? But when you put them all together, it could cause a problem. Let's add it all up.
Student loans: $34,169
529 # 1: $5,102
529 # 2: $4,227
Extra mortgage payments: $7,996
Retirement: $83,810
Total per Year: $135,304
That's a lot of money, especially once you take taxes into consideration. Tax situation varies by family, but someone who is married with two kids, saves a lot for retirement, and earns $250K could reasonably have a tax burden of about 20%, or $50K,
So this family only has $250,000 – $135,304 – $50,000 = $64,696 left to live on, of which $27,186 is committed to the mortgage. That leaves just $37,510, or $3,126 for everything else. And everything else includes a lot of stuff:
Property taxes
Insurance
Groceries
Eating out
Vacations
Car payments/Saving up for new cars
Gasoline
Ballet lessons
Clothing
Utilities
Cell phones
Netflix
Etcetera
I don't know about you, but we spend far more than $3,126 per month on everything else.
Priorities, Priorities
Now you can see why people ask about priorities. Yes, one can live spending just $3,126 per month on everything else. I call it “living like a resident“. I think it is an absolutely fantastic idea, for the first 2-5 years out of your training. But I don't want any doctor to have to do this forever. And a large percentage of them are not even willing to do it for 2-5 years. So they ask me “Should I pay off debt or invest?” or “Should I save for retirement or college?” or “Should I do Backdoor Roth IRAs or pay off the mortgage?” Underlying each of these questions is the big, huge elephant in the room—How much are you spending or do you wish to spend on your lifestyle? Because if you live very frugally, you no longer have to choose between these goals. You can do them all. But if you are not willing or not able to live frugally, then you need to change the goals (or the sequence they are worked on) until the numbers pencil out.
Let's say, for instance, that this doc insists she cannot live on less than $100,000 per year. Not $64,696. Now what? What can be changed in the financial plan to allow her to do this? Well, you'd better go back to the beginning…to the goals, and we'll make them less aggressive and see if that works out.
Pay off my student loans before age 40 age 42
Have $100,000 $80,000 each saved up for college by the time the kids turn 18
Pay off my mortgage by age 55 age 60
Retire at age 60 age 65 with $4 Million $3.5 Million in today's dollars
Now let's put an annual price tag for each of these financial goals. I won't show my work, but if you look at the equations above, you can figure it out:
Student loans: $25,455
College savings: $4,082 + $3,382 = $7,464
Mortgage (extra payments): $3,151
Retirement: $52,680
Total: $88,751
Now adding in the $50K for taxes and this doc can now spend $250,000 – $88,7512 – $50,000 = $111,249. That's $84,063 after the mortgage, or $7,005 per month. That might not qualify as “money coming out of my ears”, but it is still over twice as much to spend (after savings, taxes, and mortgage) as before.
But she didn't want $111K to spend. She wanted $100K to spend. So where should that $11K go? Well, it depends on your priorities. What's most important to you? Do you want to have those student loans paid off earlier? Great, put that extra $11K there. Now you'll have them paid off in less than 5 years (and can redirect that $11K elsewhere at that point, putting it toward your next most important goal.)
So when people ask me these sorts of questions, I can't answer them. I don't have the information. Not only do I not know what their goals are (and who are we kidding, most of them haven't bothered setting goals or writing down any kind of plan), but I have no idea how they prioritize those goals. See the problem? I mean, I can give you an answer. I can tell you what I would do. But it has little to do with interest rates, tax-protected account contribution limits, or expected investment returns. It is all about your goals. So what if you can only get $35K into a 401(k) and a Backdoor Roth IRA? If your plan is to put $53K into retirement, the rest still must go toward retirement, even if it must be invested in a taxable account. If your plan is to put $5K a year toward a college education, it doesn't matter that you can put $15K into a 529 account, you're only going to contribute $5K. If your plan is to pay off your student loans within 5 years, it doesn't really matter whether you can out invest the interest rate on the loan.
You Need a Plan
But wait, there's more. Prioritizing goals gets even more complicated when you consider some other things. For example, let's say you want to save up for the college educations before you ever start putting extra on the mortgage. Well, you can do that. It might even come out ahead mathematically if the after-tax investment return on the investments is higher than the after-tax interest rate on the mortgage. But I would start with your goals and write down your plan. Once you have saved “enough” (either total or for the year) toward a goal, you can move on to the next one, according to your priorities.
An additional complication is that it is extremely unlikely that your income will remain static over the years. For many people, income rises. They get a raise. They make partner. Production goes up. The business becomes more profitable. They hire associates. Whatever. But if you have prioritized your goals, you can direct the additional income toward the most important one (and probably spend some of it too). In fact, if you wish to spend more money, knocking off a goal (student loans, mortgage, college, etc.) can psychologically allow you to then spend what had been going toward that goal.
For other people, income falls. Maybe they are so burned out they have to cut back to part-time. Maybe they want to go on “the parent track”. Maybe a pandemic hits. Who knows? Having your financial goals prioritized again allows you to TAKE from the least important ones first.
For example, if I had to prioritize the above goals, I would do so in the following manner:
Retirement Savings
Student Loans
College Savings
Extra Mortgage Payments
If my income dropped substantially, I'd quit paying extra on the mortgage. Then once that income was used up, I'd stop saving for college, even if it meant not getting a state tax credit. Then I'd quit paying extra on my student loans. Then and only then would I start saving less for retirement. But long before I got there, I would probably be canceling vacations, taking the kids out of competitive sports, and going out to eat. However, there is nothing magical about my priorities. Personal finance is both personal and finance. This is about your goals and your priorities. I suggest you prioritize your own financial goals and use that priority list to guide you when you either have more money than expected or less money than expected to put toward your goals.
What do you think? Do you have a plan you follow for prioritizing your goals? How do you decide what is most important? Comment below!
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