Debt, House Down Payment, or 401k – How Should I Prioritize for Long Term Growth?

When I first graduated from college, I landed a good job that gave me the ability to afford costly student loan payments that, at the time, felt like a mortgage on it’s own. Like many other college grads, I found myself owing close to 6 figures after graduation, and was determined to rid myself of that debt as soon as possible. At the same time, I was concerned about “wasting” my money renting an apartment versus owning a home, and was also processing my new benefits including this whole investing for retirement thing.

Fast forward 10 years, we have experience with paying off debt early, paying PMI insurance (an extra insurance before you have 20% equity in your home), buying and selling homes, and have seen 10 years of returns in our retirement accounts. So what did we learn, what did we do right, and what would we have done differently?

Where Should We Invest?

My brother gave me the advice when I graduated to live like a poor college student as long as possible, and I pass along that advice whenever possible. Ideally, if you are applying that mindset, you will also get to make a decision of how you want to spend it to maximize your wealth long term. After covering my student loan payments and taking full advantage of my company match for retirement savings, I wanted to know how to best apply my extra savings.

In 2010, I attended a conference that offered a course about basic personal finance. After the class ended, I approached the teacher with the question “Should I pay extra on my student loans, save for a house down payment, or invest in my retirement account?” The guy looked at me like I was crazy, probably because so many of us are rushing to reward ourselves with things like a new car, a hair cut and color, new clothes, or one of the many other ways we find to spend our paychecks each month. After all, we deserve it right?

I didn’t get an answer that day, but have learned it all comes down to the interest rate that applies to each of the scenarios. Some people will tell you to pay down your smallest loan first to start the snowball affect. However, doing so could result in paying more in interest. You may also earn more money by investing than you save in interest by paying off debt early, although future performance on investments is never guaranteed.

If you are paying on debt, you need to understand how much you are paying in interest. While past performance isn’t a promise of future performance, the additional contributions to your 401k could earn 7-8% depending on how they are invested between stocks and bonds and the performance of the stock market. If you are only paying 3% or less on a debt, you may be better off earning more by investing the money instead.

Option 1: Student Loans

When I graduated, I went from working multiple minimum wage jobs to an entry level engineering job. Since I had already been laid off less than 2 years prior, it seemed too good to be true and I was waiting for the day I’d be let go again.

I prioritized my high interest rate loans first (7-8%), and then paid off the loans with 3-4% interest rate. I wanted zero debt as soon as possible because if forced back to my minimum wage jobs, I didn’t want to juggle student loan debt on top of it.

Simplifying this to a $85,000 loan with 6% interest for 20 years, we can assume I paid an average of $510 per month additional to pay off the loan in 8 years. The calculator below confirms that this was almost $40,000 in interest saved over the life of the loan which is awesome! But could we have done better?

Projection from Calculator.net

Option 2: Invest in Retirement Savings Accounts

While I am extremely thankful that my student loans are paid off today, I do question how much I would have earned from investing into my tax deferred retirement savings instead. Not only would I have lowered my taxable income, but since the inception of the S&P 500 in 1926, the average annual return has been about 8%. The S&P 500 was worth about $1,200 my first year of employment and 10 years later is worth about $3,600, which is about 9-10% returns annually on average.

In other words, if I stuck to the original payoff schedule, but instead invest the $510 per month for 8 years, how much would this be worth if we recognize an investment gain of 8% annually?

Projection from Calculator.net

After 8 years, the $510 invested at 8% would be worth $67,499. By not paying the additional amount on the student loans, we would still owe $62,403 after 8 years. Therefore, the result of the two scenarios we looked at are:

  1. Pay off student loans early – Net $0 after 8 years
  2. Invest money for 8% returns vs 6% interest on student loans: $67,499 – $62,403 = Net $5,096 Positive

If the interest on my debt was lower (say 3%), my investments were put into a tax deferred account, or my interest earned was higher (9-10%) this delta would be even higher.

Option 3: Save for a House Down Payment

My husband and I went a nontraditional route when we bought our first house. We weren’t married, so my husband had $5,000 in savings to put down on a house and I paid him rent. If anything happened, I would move out and he would keep the house. Because we only put down $5,000 on a $145,000 house, we had less than 5% of equity in the house and had to pay PMI insurance which was about $60 per month. We would have needed an additional $24,000 down in order to avoid paying the additional PMI insurance.

At the time we didn’t pay extra on our house because we weren’t married and my husband was content paying the PMI and keeping the cash. We bought our second house shortly after we got married, and I was determined to put 20% down to avoid wasting money on PMI insurance. Our second house was about $200,000 which required we pay $40,000 down to reach the 20%. At the time, it seemed really smart, but would we have done things differently if we went back and did it again?

NertWallet has a PMI calculator that suggests if we only put down 5% ($10,000) on our house, we likely would pay $80 per month for the additional insurance. Paying the $80 per month would have freed up $30,000. If we instead invested the $30,000 for 8% returns then we would earn $2,400 per year or about $200 a month initially. When we buy a house, it’s not only the mortgage insurance we pay, we also have additional interest we must pay on the higher principle, therefore our two options are shown below:

  • $160k Mortgage Balance: Est $6,400 in interest year 1 (4%) or average $533 monthly
  • $190k Mortgage Balance: Est $7,600 in interest year 1 (4%) or average $633 monthly and $80 monthly in PMI insurance, Invest additional $30,000 instead.

We could have invested $30,000 for about $200 in interest earned per month. Doing so would require us to pay an extra $100 in interest per month for the first year and $80 a month in PMI insurance – Net $20 more per month which would continue to grow with compounding interest. In other words, your mortgage interest will decrease over time, however you interest earned on the savings will grow higher in future years.

Takeaway

At the end of the day, it comes down to your tolerance for risk. After being let go in 2009 before I even started my career, my tolerance for risk was low because I was concerned I would be laid off again. I invested in reducing my debt because there was an agreement I made with my lender and I had full confidence in the money I would save by doing so.

If I knew then what I know now, I would have taken advantage of my 401k contributions to invest money before paying taxes and recognize higher returns. During the last 10 years, the interest earned in my retirement accounts would have made up for any interest I was paying on my debt or PMI insurance for a mortgage. Remember, past performance isn’t a guarantee of future performance, however over the long run the stock market has to date always bounced back and delivered.

That being said, I sleep good at night knowing I have lived frugally to pay off my debt and building equity in my home. I can’t control the performance of the stock market, but a loan agreement is guaranteed and easy to calculate what you will gain by paying off debt early or avoiding a higher mortgage loan. As long as we are investing in any of these three above the minimum, we are setting ourselves up for success long term and are unlikely to regret doing so.

Questions to ask yourself:

  • How much interest are you paying on your debts?
  • What returns are you seeing in your retirement savings account?
  • Is PMI insurance worth it for your situation, and are you better off saving that cash for another investment?
  • Are you rushing to pay down low interest loans (ex: 0% car payment) and missing out on tax savings or higher returns through an account like a 401k?
  • Are you taking full advantage of the employer contributions for your retirement accounts?

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3 thoughts on “Debt, House Down Payment, or 401k – How Should I Prioritize for Long Term Growth?

  1. Very good article, I’ve never really thought of do a cost benefit analysis of paying PMI vs investing the deposit. I have beaten myself up self up over the opportunity cost of buying a house vs renting. If we stayed in our rental house were we’d have saved $7k a year. That in conjunction with a $50k Down payment would be a significant amount six years later.

    Still I can’t change the past so I look on the bright side of enjoying a nicer home. Instead I encourage everyone to do an analysis in the costs of renting vs buying before they take on a 30 year loan.

    As for paying off debt vs investing I’ve always used the 4% rule as a starting point. As most advisers tell you if you can live off your portfolio yielding 4% you should be good for retirement.

    So all debts with interest above 4% I prioritize paying early over savings, all debts below that I prioritize investing extra cash.

    Liked by 1 person

    1. 4% is a really good level to set, especially since that value has some strong support from the retirement community so expected long term benefit from your investment.

      I didn’t cover rent vs own here, but I agree, there is a huge opportunity to save money renting depending on your scenario. That decision can be unique to different locations though. It’s also recently changed with the standard deduction being much higher now, so it’s unlikely to provide a tax benefit unless you’re already writing off a significant number of deductions. Not to mention selling is also really expensive.

      We could have saved more money buying, but to do so I think we would have stayed in a smaller home or apt to do so. Since we have kids, were appreciative of more space for then to run outside, but challenged ourselves not to get a huge house to keep the mortgage similar to our rent payment.

      I was interested to run through the PMI scenario. I’ve seen where people who buy properties to rent can actually recognize a higher ROI by paying PMI and saving the downpayment to purchase another property instead. It’s a different mindset to what I had initially.

      Like

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