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Preston Victory
August 21, 2024
Welcome, Future Early Retirees.
When it comes to managing your finances, one common dilemma faced by many individuals is whether to prioritize investing or paying off student loans. Both options have their merits, but usually only one side of the argument is presented. I want to explain the other side. Prioritizing investments can be a better decision in the long run.
In today’s newsletter:
The time value of money
The concept of the time value of money suggests that money available to you today is more valuable than the same amount in the future. By investing your money today, you have the opportunity to generate returns and grow your wealth over time. By focusing on investing rather than solely paying off your student loans, you can potentially benefit from the power of compounding and allow your investments to work for you.
Imagine your goal is to retire by 65. Consider two scenarios:
Investing at age 30: If you invested $100,000 at age 30 and didn't add any more, assuming an average annual return of 10%, you would have about $4.3 million by age 65. This would be equal to having $1.3 million in todays money (got to love inflation 🙃).
Investing at age 40: If you waited until age 40 to invest the same $100,000 with no additional contributions, again assuming a 10% average annual return, you would have approximately $1.5 million by age 65. This would be equal to having $500,000 in todays money.
See the difference? Compound interest is real!
Key Takeaways:
The time value of money concept suggests that money today is more valuable than the same amount in the future, as investing now allows for potential wealth growth over time.
Investing $100,000 at age 30 with a 10% annual return could yield $4.3 million by age 65, equivalent to $1.3 million in today's money.
Compare that to delaying investing until age 40 with the same amount and return rate would result in only $1.5 million by age 65. Big difference.
What about all the additional interest you are going to have to pay?
Great question! Let's dive into this often misunderstood aspect of personal finance.
While being debt-free feels great, it's crucial to consider alternative approaches. Even a small difference between interest rates and your return can have a significant impact over time. Here's why:
Compound interest works in your favor when investing
The S&P 500 has averaged over 11% annual returns for 100 years
Even a conservative 10% return can outpace many loan interest rates
A Real-World Example
Let's consider a recent graduate with $100,000 in student loan debt at 8% interest:
Loan term: 30 years
Monthly payment: $735
Total interest paid over 30 years: $164,000
Now, let's compare this to investing:
Invest $350 monthly (less than half the loan payment)
Assuming 10% average annual return
After 30 years: $757,000 portfolio value
Even at 9% return: $622,000 portfolio value
That difference is quite big!
Important Considerations
High-interest debt (above 8.5%) should still be prioritized or this strategy could have the opposite effect as intended.
Credit cards (avg. 25% interest) can quickly negate investment gains
Always understand your current and future interest rates
Consider locking in fixed interest rates for predictable payments
Finding Your Balance
Remember, there's no rule against investing while in debt. My wife and I use a hybrid approach. We invest monthly, but are aggressively paying down our student loans. While this approach may be best for us, your circumstances may differ, leading to a different approach. That's okay! The most important factors are:
Spending less than you earn
Sticking to your budget
Following through on your financial plan
By considering these factors and understanding the power of compound interest, you can make an informed decisions about how you want to approach student loans.
Key Takeaways:
Compound interest can work in your favor when investing, with the S&P 500 averaging over 11% annual returns for 100 years, potentially outpacing many loan interest rates.
A real-world example shows that investing $350 monthly at a 10% return could yield $757,000 after 30 years, compared to paying $164,000 in interest on a $100,000 student loan at 8% interest.
While high-interest debt should be prioritized, a balanced approach of investing while paying down debt can be effective, with the most important factors being spending less than you earn, sticking to a budget, and following through on your financial plan.
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