Forecasting Long Term Wealth: Debt Reductions vs Investments

Asset ownership or debt reduction? A common question considered, yet a question frequently simplified down to determination by simple interest rate differentials (the separation between interest charged on debt and the rate of return expected on your investment portfolio). Life, especially the interrelationships of economics and the underlying mathematics, is not so simple.

There are many variables involved in determining the balance or emphasis between reducing debt and investing for intelligently structuring the maximization of your long-term wealth: outstanding liabilities, interest rate(s) on liabilities, expected inflation and wage growth, future interest rates, minimum monthly payments, contractual duration of liabilities, tax-deductibility of particular interest expenses, investment account tax advantages, future tax rates, excess income (savings), employer match, asset allocation, expected return, etc. The world is complex and variable. Therefore, there is no universal optimal solution for every citizen in our society because unique personal financial conditions and priorities interact with economic realities and expectations, necessitating informed judgments for financial optimization.

Although there may not be a single solution, some reasonable hypothetical scenarios regarding savings and debt levels provide guidance for the proper allocation of excess income (savings) between debt principal and one’s investment portfolio. Concentration is on the influence of excess income (savings) because it is assumed that all living expenses and debts are properly paid to maintain credit quality before considering allocating any residual income (savings) to an investment portfolio. If your income exceeds the total of your necessary monthly expenses, will you maximize the improvement in your future financial condition (net asset position) via purely reducing the principal on your debt, balancing between reducing debt principal and investing, or purely investing the excess income?

Scenario A- $500 Monthly Savings Purely for Debt Principal Reduction

If the 4% employer 401k match is provided on a $65,000 annual salary, then a $100 bi-weekly employer contribution is added to the individual’s bi-weekly employee contribution. The benefits from reducing gross taxable income from the 401k employee contribution would effectively increase the contribution to, let’s say, roughly $300 bi-weekly rather than the $250 bi-weekly excess net income without harming the net income required by the individual. The $5,000 credit card balance would be eliminated within approximately ten months before transferring the $500 in excess net income (plus an additional $100 from no credit card payment) to reducing the principal on the auto loan. With the credit card balance eliminated and the excess principal payments on the auto loan beginning at the end of the eleventh month into the future, the 5-year auto loan at 7% would be eliminated in slightly less than 3 years (33 months) from now.

Having eliminated the credit card debt in 10 months to make available roughly an extra $60 in gross income bi-weekly for investment while also having eliminated the automotive loan in 33 months to make available another approximately $370 in gross income bi-weekly for investment. There remains a little more than 7 years for contributing to the 401k in the 10-year period of consideration. Now with bi-weekly contributions of $830 after debt elimination ($300 employee contribution, $100 employer contribution, $60 credit card elimination contribution and finally the $370 auto loan elimination contribution) for a total principal investment of $21,580 per year (although reducing to $730 bi-weekly once factoring in $100 gross income at the start of the fourth year for about $2,000 in annual auto maintenance expenses) - the future value at the end of 10 years at 7% compounded bi-weekly would be roughly $187,000. If the annual expected return declined from 7% to 5%, then the future value would decrease to approximately $173,000. Comparatively, if the annual expected return increased from 7% to 9%, the future value would improve to nearly $203,000 in 10 years. Consequently, by prioritizing the elimination of credit card debt followed by the automotive loan, the expected future nominal change in net worth of the individual after 10 years would be in a range of $208,000 to $238,000 when combining debt elimination and asset accumulation.

Scenario B- $500 Monthly Savings Split for Debt Principal Reduction & Investment

In this scenario, let’s assume someone has a $30,000 auto loan at 7% for 60 months requiring a monthly payment of $594 per month and credit card debt of $5,000 associated with a 23% annual percentage rate (APR) and a starting minimum monthly fee of approximately $100 (which would decline as the balance declined). We consider the change in net worth of the individual after 10 years if they allocated their $500 monthly excess income evenly between eliminating their credit card balance first and then the auto loan principal while simultaneously expanding their investment portfolio. As before in Scenario A, we will also vary the expected return between 5%, 7%, and 9% to see how the approximated change in net worth is influenced by the expected return.

As explained in Scenario A, the bi-weekly employer contribution of $100 is added to the individual’s bi-weekly employee contribution. The benefits from reducing gross taxable income from the 401k employee contribution would effectively increase the employee contribution to, let’s say, roughly $150 bi-weekly rather than the $125 bi-weekly ($250 monthly) excess net income intended for investment without harming the net income required by the individual and before considering the additive effect of debt elimination on the bi-weekly contribution. The $5,000 credit card balance would be eliminated within approximately 20 months before transferring the $250 in excess monthly net income to reduce the principal on the auto loan (plus an additional $100 from no credit card payment). With the credit card balance eliminated and the excess principal payments on the auto loan beginning at the end of the twenty-first month, the 5-year auto loan at 7% would be eliminated in about 3.7 years (44 months) from now. Having eliminated the credit card debt and automotive loan in less than 4 years while still managing to invest $250 bi-weekly ($150 employee + $100 employer) into the 401k (before the $100 reduction from bi-weekly gross income intended for auto maintenance begins at the end of the fourth year), there remains basically 6.6 years to start contributing a higher amount to the 401k in the 10-year period. By increasing bi-weekly contributions from $250 to $730 ($300 employee contribution plus $100 employer contribution and $60 credit card elimination contribution and finally the $270 auto loan elimination contribution after $2,000 allocated annually for car maintenance), the future value at the end of 10 years at 7% compounded bi-weekly would be roughly $197,000. If the annual expected return declined from 7% to 5%, then the future value would decrease to approximately $180,000. Comparatively, if the annual expected return increased from 7% to 9%, then the future value would improve to about $215,000 in 10 years. Consequently, by balancing the elimination of credit card debt followed by the automotive loan with also investing in a 401k, the expected future nominal change in net worth of the individual after 10 years would be in a range of $215,000 to $250,000 when combining debt elimination and asset accumulation.

Scenario C- $500 Monthly Savings Purely for Investment

In this scenario, let's assume someone has a $30,000 auto loan at 7% for 60 months requiring a monthly payment of $594 per month and credit card debt of $5,000 associated with a 23% annual percentage rate (APR) and a starting minimum monthly payment of approximately $100 (which would decline as the balance declined). We consider the change in net worth of the individual after 10 years if they allocated their $500 monthly excess income purely to expanding their investment portfolio while satisfying their minimum monthly payments on their credit card and automotive loan. If the 4% employer 401k match is provided on a $65,000 annual salary, then a $100 bi-weekly employer contribution is added to the $300 bi-weekly employee contribution (as mentioned, the reduction in gross taxable income slightly increases the feasible contribution from $250 to roughly $300 bi-weekly) for a total investment of $400 bi-weekly into a 401k. The $5,000 credit card balance would barely be reduced by roughly 10% as the monthly payment would almost purely be counteracted by interest every month. Satisfying the minimum monthly payments on the auto loan would mean paying every expected payment from origination, therefore the 5-year auto loan at 7% would be eliminated in 5 years (60 months) from now.

With bi-weekly contributions of $400 ($300 employee plus $100 employer contributions) that eventually decline to $300 once accounting for the $100 bi-weekly gross income for car maintenance before returning to $670 once the car loan is eliminated. The future value at the end of 10 years at 7% compounded bi-weekly would be roughly $189,000. If the annual expected return declined from 7% to 5%, then the future value would decline to roughly $172,000. Comparatively, if the annual expected return increased from 7% to 9%, then the future value would improve to nearly $209,000 in 10 years. Consequently, by only satisfying the minimum payments on the credit card and the auto loan, the expected future nominal change in net worth of the individual after 10 years would be in a range of $203,000 to $240,000 when combining debt elimination and asset accumulation.

Principles & Priorities

With the expected annual return at 5%, the change in net worth of Scenario A would be $208,000. The change in net worth of Scenario B would be $215,000, and the change in net worth of Scenario C would be $203,000. With the expected annual return at 7%, the change in net worth of Scenario A would be $222,000. The change in net worth of Scenario B would be $232,000, and the change in net worth of Scenario C would be $220,000. With the expected annual return at 9%, the change in net worth of Scenario A would be $238,000. The change in net worth of Scenario B would be $250,000, and the change in net worth of Scenario C would be $240,000. It is also worth considering that the monetary differences widen between scenarios, assuming consistent assumptions, as we extend the period from 10 years to 20 years to 30 years and beyond. What seems like a slight separation in results between alternatives in the short-term may become a significant separation in the moderate to long-term.

In this particular limited set of simplified scenarios with many implicit assumptions, the change in nominal net worth of the individual 10 years into the future with different expected portfolio returns is consistently maximized through Scenario B by splitting excess income between reducing debt and 401k contributions rather than purely prioritizing debt reduction before investing or purely concentrating on accumulating assets. This simplified example reveals the more complicated nature of a complex reality, considering only a few variables were explicitly stated rather than the multitude of variables and assumptions determining reality. It is evident that there is no universal solution for the wide range of human financial conditions interacting with variable economic conditions expectations and personal priorities.

By concentrating purely on reducing debt (assuming it is not a large amount of extremely high-interest debt) rather than at least contributing a portion of excess income to investing, then the exponential benefits received from compound interest (earning a return on the increasing portion of assets generated from prior returns) are delayed and forever sacrificed (although higher expected excess income invested in future periods from wage growth or debt reduction may help counteract the lost benefits of compounding). By concentrating purely on accumulating assets (assuming there is not an available exceptionally high expected return) rather than also reducing additional debt principal, then one is incurring higher interest expense as a portion of the total liability and reducing their otherwise higher future excess income available for investment.

You must thoughtfully calculate your specific future with reasonable assumptions to know what balance (or emphasis) between debt reduction and asset accumulation is probably (rarely certainly) optimal for you. The more extreme scenarios of interest cost or expected return are essentially self-evident regarding prioritization. Still, the world is dynamic operating between the extremes with inputs and decisions not always obvious. A comprehensive analysis involving logically-valid input factors and well-informed (conservative) expectations does not guarantee a more appealing result. Still, it does aid in justifying your deserving of a more pleasant result. Without having performed an informed and thorough analysis, unless a “large” amount of debt or significant cost of debt exists, I would consider it wise to immediately begin at least allocating a portion of your excess income to investing to allow the benefits of matching and compounding to increase the probability of an easier transition into retirement.

Written by Hunter Biggs

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