Snowball. Avalanche. Gazelle.
Search engine optimization (SEO) words for the National Geographic, you ask?
Maybe, but they’re also terms for debt-payoff strategies popularized by personal finance commentators. Being debt-free, and getting there as fast as possible, are widely promoted in the personal finance community. This is, of course, a good thing. Having no debt is a great accomplishment and can come with some real emotional benefits. Some people feel less stress just knowing they don’t have debt payments.
With that said, here’s my zag—I think this idea has been over-emphasized.
The general point of a fast debt payoff is to get to a positive net worth, but there’s a reason it’s called a balance sheet. There’s more than one way to get to net positive. Think of it as a scale where zero debt and zero assets on one side equals $50,000 in debt and $50,000 in assets—both give you a net worth of zero.
Even though the net worth is the same, I think the person with $50,000 in assets and debt enjoys more financial flexibility. A question worth asking: Would your debt worry you as much if you had an equal amount in savings?
Of course, not all debts are created equal. Credit-card debt is not to be messed with. Prioritize getting rid of credit-card or other high-interest loans as quickly as possible. On the other hand, debts such as student loans, car loans, and mortgages generally come with lower interest rates. Some savings and asset-building can often be prioritized over paying off these types of loans quickly.
The fastest way to fall into debt is by not putting away any emergency savings. Imagine putting all your extra income into paying off debt—instead of saving some—and then your car breaks down. Or, you get hit with your medical deductible. Where’s that cost going to go? Right to your credit cards, and you’re now in more debt. Building savings for these types of emergencies is foundational to good finances.
Matching employer retirement plans
Compare the expected return from an asset to the interest rate being charged on the debt as one strategy for deciding to build savings versus paying debt. In other words, will the asset make you more money than the debt will cost you?
In general, if the expected return from the asset is higher than the debt interest rate, it’s a good financial decision to choose the asset. (This ignores the emotional benefits of paying off debt but highlights the importance of approaching these decisions from varied angles.)
A rough estimate for the historical long-term expected return for traditional bond and stock funds in your retirement account would be 4% to 10%, depending on the allocation. As is, this is a win against many low-interest rate debts, but it’s just the start.
An employer match means your employer contributes for you as well, potentially an amount equal to your contribution. For example, you put in $200 per paycheck, and your employer also puts in $200. In this scenario, you’ve made a 100% return just by putting money into the account, not counting any future returns. A huge win!
Additionally, if it’s a traditional retirement account, you’ll also get an immediate tax break. Depending on your tax bracket, this tax break can be anywhere from 10% to 37%.
Health savings accounts
The argument for health savings accounts (HSAs) is similar to that of employer retirement plans. You can invest your savings, employers often match or make contributions on your behalf, and there are major tax benefits. Even better than retirement accounts, HSAs are the only account where it’s possible to never pay taxes on the money contributed. Also, some HSAs offer you a small return on your money once you build the account to a minimum amount. Lastly, it’s much easier to access the money in your HSA by using it for qualified medical expenses. It contributes to your ability to handle emergencies.
All of this contributes to an immediate return that’s much higher than many debt interest rates.
These are just three examples of why building savings and assets can be as powerful as paying off debt. Student loans provide an opportunity to exploit this further if you’re able to qualify for public service loan forgiveness.
The ability to build assets while pursuing forgiveness can be a boon to your finances once the loans are wiped away.
Jacob W. Parish, a certified financial planner™ professional, focuses on helping audiologists, SLPs and other young health care professionals navigate financial planning issues. Visit his website, Schooner NextGen, or follow @SLP_Finance. Securities and Advisory services offered through Geneos Wealth Management, Inc. Member FINRA/SIPC