The debate over whether to pay off debt or invest is alive and well.
On one hand, you have the debt free community who prioritizes paying off debt to achieve financial freedom.
On the other hand, you have a segment of the wealth community who prioritizes purchasing income-producing assets over building wealth. From their perspective, it is more financially productive to use that passive income to both pay off debt and build wealth.
So, who’s right?
Well, here is what Padric Scott, a Florida-based Certified Financial Planner (CFP) and Wealth Management Certified Professional (WMCP), has to say about the debt versus income conversation:
“When making the decision on whether to reduce debt or invest, you should adequately weigh emotional and economic factors.
Emotionally, you might be frustrated with debt. Whether it’s because the debt is associated with financial trauma or because any type of debt brings you anxiety, the emotional factor might influence you to prioritize debt reduction.
Economically, however, you might find long-term financial value in slowly paying off debt as you simultaneously invest.
Let’s break the economic factor down in two sectors:
Reframing Debt
I’ve worked with doctors, dentists, pharmacists, social workers, engineers and other professionals who will be ecstatic about taking on a $380,000 mortgage, but detest their $200,000 student loan debt.
What they do not realize is, that $200,000 student debt was an investment towards a $300,000 annual salary. Over a ten year career, that is $3 million of earnings. Over 30 years, that is approximately $9 million of cash generated from a $200,000 down payment.
Plus, when we account for inflation, that investment brings us north of $12 million in earnings.
Also, even if a $100,000 student loan only leads to a $50,000 annual salary, that is about $1.5 million of income generated from $100,000 down payment.
We have to start looking at our financial decisions as investments in ourselves that produce income, the same way we would an investment in a business.
Net Present Value
I want to introduce two business concepts here that guide investment decisions – net present value and net worth.
Net present value (NPV) tells us the time value of money –
NPV = F / [ (1 + r)^n ]
F = Cash flows.
r = Discount rate
n = Number of periods in the future based on cash flows.
Ideally, the NPV of your investment should be positive. A positive NPV means you you will have a positive return on your investment, something the business folks call ROI.
NPV pushes you to ask this key question about your personal financial decisions:
‘Does this decision today, based off of the future earnings I could make in an investment elsewhere, increase or decrease my present day net worth?’
These metrics should drive how you prioritize your money absent emotional desires.
Net Worth
The net worth metric, in particular, can have a substantial impact on your financial legacy.
Net Worth = Assets – Liabilities.
To increase your net worth today, you can either increase your assets at a rate faster than you can decrease your liabilities, or decrease your liabilities at a rate faster than you can increase your assets.
Here is an example –
Let’s say you prioritize investing and use a 7% interest rate as your benchmark.
From there, you want to look at the interest rates tied to your debt. If the rate on your liabilities is higher than your benchmark, such as a credit card debt at 24% Annual Percentage Rate (APR), it is best to aggressively eliminate that high interest debt.
On the other hand, if you have a car loan with a 3% APR, then you would rather pay the minimum towards that debt because each additional dollar you commit is only locking in a 3% gain to your net worth.
Whereas, you could have been locking in a 7% gain to your net worth by putting additional dollars into an investment account.”
Conclusion
Identify goals, and then reallocate resources to capture the best net effect for your household. This is what Mr. Scott calls “issuing a priority score” to one’s financial goals.”
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, investment or accounting advice. This information is not endorsed by a financial institution. You should consult your own tax, legal and accounting advisers before engaging in any transaction.