The Best Financial Decision Isn’t Always the Most Obvious One

July 27, 2017

Let’s suppose you have sufficient emergency savings and are maxing the match in your 401(k). You now have several options of what to do with your extra savings. One is to pay down a student loan with a 3.7% interest rate, the second is to invest more for retirement, and the third is to pay down a mortgage with 3.85% interest rate (2.81% after factoring in the tax deduction). Which would you choose? This is the real life scenario of an employee I recently spoke with, so let’s explore the options.

Option 1: Pay down 3.7% student loan

Her initial instinct was to pay down the student loan because it annoyed her the most and she was worried about having that debt if she were to lose her job. But making payments towards the debt wouldn’t actually make her more financially secure until it was completely paid off. In the meantime, she would actually be safer having more in savings and investments that she could use to make the loan payments in case she found herself in between jobs.

Option 2: Invest more toward retirement

She could reasonably expect to earn more by investing her savings than she would save in interest by paying down the loan early, as long as she invested for longer-term growth and wasn’t too conservative. (My general rule of thumb is to pay off debt first if the interest rate is 6% or more, invest if the interest rate is below 4%, and go either way depending on how aggressive an investor you are if the interest rate is between 4-6%.) Of course, she could still decide to pay the student loans for emotional reasons, but investing would likely give her a better return on her money.

Option 3: Pay down 3.85% mortgage

In the end, we decided that it actually made the most sense for her to pay her mortgage down. At first, that didn’t seem to make sense since the mortgage interest rate is even lower than the student loan after the tax deduction. (Her income is too high to deduct the student loan interest from her taxes.)

However, it turned out that she had to pay PMI (private mortgage insurance) until she had 20% equity in her home. When we calculated how much she would save each year in PMI payments as a percentage of the mortgage balance she’d have to pay down, it was 6%. When you add that to the 2.81% interest rate, she would save a guaranteed 8.81% on the money she put towards getting that 20% in equity!

The moral of the story

When deciding between alternative options, first figure out what the expected return on your money would be, either in savings by paying down debt or earnings from investments, but be sure to factor in ALL the possible savings and earnings. (A qualified financial planner can help you do this so long as they aren’t biased towards one choice or another.) Finally, don’t forget the “happiness factor.” If, after looking at the numbers, she decided that paying off the student loan would make her happier overall, that’s fine too…as long as it’s an informed decision.

Want more helpful financial guidance, delivered every day? Sign up to receive the Financial Finesse Tip of the Day, written by financial planners who work with people like you every day. No sales pitch EVER (being unbiased is the foundation of what we do), just the best our awesome planners have to offer. Click here to join.