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by Gene Dongieux, CIO, Mercer Advisors
Q I just paid off my practice loan and my credit cards, so I have some extra cash. I don't know whether I should pay down my student loans or mortgage first. (Did I mention it felt really good to pay off that debt?) My wife wants me to save for retirement. My older brother (also a dentist) wants me to get a Mercedes like his, but I couldn't enjoy it while I'm still in debt. My mortgage lasts until I'm 64. I don't want to retire with a mortgage, and I want to retire before 64.A Debt is not all bad. True, you can get into trouble with 21 percent credit card debt and huge car payments, but you can also lose out by banishing debt altogether. If you're looking for greater long-term net worth, compounded earning on investments will help you more than paying extra on low-interest fixed debt, especially if that debt offers tax advantages like home mortgage interest. If that sounds counterintuitive, you're not alone.
People think of debt and investments in black and white when it's really a continuum of income and outgo. You did not say what your interest rates are/were, but consider this example for just the basic rates:
You knew to pay off high-interest credit cards first, but let's look at what should come next. Suppose you are paying 5 percent on a $100,000 school loan. For the sake of easy math, let's say that you pay $5,000 a year. As a result of paying off your practice and credit card debt, you will have $40,000 cash to either invest or pay down debt at the beginning of each year. If you pay down your school debt to $60,000, you save yourself $2,000 in interest this year. If you invest the money at 10 percent, you earn $4,000, giving you a net (before tax) of $2,000 more. Plus, you now have $44,000 invested for next year.
If you are comparing home mortgage debt, you can gain even more by investing. Interest you pay on a primary residence mortgage is subtracted from taxable income. If you are in the 35 percent tax bracket and pay $35,000 a year in mortgage interest, that $35,000 is deducted from your taxable income. That means you pay about $10,000 less in taxes. Because this savings is attributed to your mortgage, the real cost of your mortgage interest is not $35,000 but $25,000 a year.
But the real key is to realize that saving compounds. Fixed debt, like your mortgage and school loans, does not. Most people grossly underestimate the power of compounding. When you had a credit card balance, you saw the power of compounding as your balance got larger and larger, seemingly by itself. When you save and invest, the compounding works in your favor.
Compare the results of an early investor vs. a late investor. The early investor contributes $30,000 per year for eight years, then never contributed again. The late investor paid down his debt for 10 years and then started saving. He contributed $30,000 per year for 50 years! Both earn 8 percent (a fairly conservative long-term return, but more than the average investor earns because the average investor jumps around too much). Even though the late investor contributes more, he never catches up. After 20 years, the early investor has roughly twice as much as the late investor.
Neither your mortgage nor your student loans are compounding. There is no reward for making payments early instead of on time, but there is a substantial reward for investing now instead of later. Dentists start working at a later age and generally want to retire sooner, so it's even more important to invest early and often.
Because few people really understand geometric progression, we significantly underestimate what we are capable of in the long term. Debt looks big because it's right in front of us, while compounded returns are off in some distant future. That's why smart people don't rely on gut instinct to make important financial decisions. It may feel good to pay off debt, but it should feel even better to do something smarter.
Gene Dongieux is the author of If You Have It Made, Don't Risk It: A Physician's and Dentist's Guide to Investing. As chief investment officer for Mercer Advisors, he manages more than $3 billion in client assets. Dongieux has been quoted in "The Wall Street Journal" and "Investment Advisor" magazine. Contact him at [email protected].