By Dr. James M. Dahle, WCI Founder
You need to prioritize your financial goals to answer the most common questions directed at bloggers and financial professionals.
I am inundated with questions such as:
“As a young physician who graduated last year, I'm trying to decide if I should prioritize completely paying off my very large student loan debt ($400K @ 4.5%) or if I should prioritize retirement even though the expected payoff might be less than 6%.”
or
“Is there any point to setting up a 529 for your kid if you aren’t maxing out your 401(k) yet?”
Unless and until you are debt-free, you will always have the invest vs. pay off debt dilemma. However, there is more to this conversation than I usually see discussed. The issue is really a question of weighing various priorities inside of a financial plan and then directing available cash flow toward those priorities in a way that ensures they are each reached at the appropriate time while taking advantage of all possible tax and investment benefits. Let's come up with a hypothetical investor and some hypothetical goals to illustrate the point.
Setting SMART Financial Goals
Let's say a 35-year-old physician investor earns $250,000 per year, owes $150,000 in student loans at 4.5%, has a $500,000, 3.5% 30-year mortgage, has two children (two and four), and wants to retire someday. Perhaps they write a financial plan that includes the following goals:
- Pay off my student loans before age 40
- Have $100,000 saved up for college by the time each kid turns 18
- Pay off my mortgage by age 55
- Retire at age 60 with $4 million in today's dollars
With specific financial goals, one can work backward using reasonable assumptions to determine how much money must be put toward those goals each year to reach them on time. Let's take them one by one.
Calculations for Your Financial Goals
The doctor has five years to pay off student loans. That's about $30,000 per year, plus interest. A simple spreadsheet calculation will tell them exactly how much they need to put toward those financial goals to reach them.
=PMT(4.5%,5,-150000,0) = $34,169 per year for five years
The doc has 14 years for child #1 to hit $100,000 in their 529. Same calculation, different numbers. We'll have to assume an investment return. Since 14 years is a long time, let's use “real” after-inflation numbers so you end up with $100,000 in today's dollars. Let's use 5% real. If you think that's too low or too high for your taste, you know how to adjust according to your crystal ball.
=PMT(5%,14,0,100000) = $5,102 per year for 14 years
Child #2 has 16 years. We'll use the same assumptions.
=PMT(5%,16,0,100000) = $4,227 per year for 16 years
They have 20 years to pay off that 30-year mortgage. The regular payment on the mortgage (not counting insurance and taxes) is:
=PMT(3.5%,30,-500000,0) = $27,186 per year for 30 years.
To cut that down to 20 years, just change 30 to 20 in the calculation.
=PMT(3.5%,20,-500000,0) = $35,181 per year for 20 years
So the physician will need to pay an extra $7,996 per year, or $666 per month, to pay it off 10 years early.
They want $4 million for retirement in 25 years. Again, it's a long period of time so let's use a real 5%.
=PMT(5%,25,0,4000000) = $83,810 per year
Adding It All Up
If you look at any of those calculations individually, none of them seem terribly unreasonable, right? But when you put them all together, it could cause a problem. Let's add it all up.
- Student loans: $34,169
- 529 #1: $5,102
- 529 #2: $4,227
- Extra mortgage payments: $7,996
- Retirement: $83,810
- Total per Year: $135,304
That's a lot of money, especially once you take taxes into consideration. Tax situation varies by family, but someone who is married with two kids saves a lot for retirement and earns $250,000 could reasonably have a tax burden of about 20%, or $50,000.
So this family only has $250,000 – $135,304 – $50,000 = $64,696 left to live on, of which $27,186 is committed to the mortgage. That leaves just $37,510, or $3,126 per month for everything else. And everything else includes a lot of stuff:
- Property taxes
- Insurance
- Groceries
- Eating out
- Vacations
- Car payments/saving up for new cars
- Gasoline
- Ballet lessons
- Clothing
- Utilities
- Cell phones
- Netflix
- Etc.
I don't know about you, but we spend far more than $3,126 per month on everything else.
Priorities, Priorities
Now you can see why people ask about priorities. Yes, one can live spending just $3,126 per month on everything else. I call it “living like a resident.” I think it is an absolutely fantastic idea for the first two to five years out of your training. But I don't want any doctor to have to do this forever. And a large percentage of them are not even willing to do it for two to five years.
So, they ask me “Should I pay off debt or invest?” or “Should I save for retirement or college?” or “Should I do Backdoor Roth IRAs or pay off the mortgage?” Underlying each of these questions is the big, huge elephant in the room—how much are you spending or do you wish to spend on your lifestyle? Because if you live very frugally, you no longer have to choose between these goals. You can do them all. But if you are not willing or not able to live frugally, then you need to change the goals (or the sequence they are worked on) until the numbers pencil out.
Let's say, for instance, that this doc insists they cannot live on less than $100,000 per year. Not $64,696. Now what? What can be changed in the financial plan to allow them to do this? Well, you'd better go back to the beginning . . . to the goals, and we'll make them less aggressive and see if that works out.
- Pay off my student loans before
age 40age 42 - Have
$100,000$80,000 each saved up for college by the time the kids turn 18 - Pay off my mortgage by
age 55age 60 - Retire at
age 60age 65 with$4 Million$3.5 million in today's dollars
Now let's put an annual price tag for each of these financial goals. I won't show my work, but if you look at the equations above, you can figure it out:
- Student loans: $25,455
- College savings: $4,082 + $3,382 = $7,464
- Mortgage (extra payments): $3,151
- Retirement: $52,680
- Total: $88,751
Now adding in the $50,000 for taxes, and this doc can now spend $250,000 – $88,7512 – $50,000 = $111,249. That's $84,063 after the mortgage, or $7,005 per month. That might not qualify as “money coming out of my ears,” but it is still over twice as much to spend (after savings, taxes, and mortgage) as before.
But she didn't want $111,000 to spend. She wanted $100,000 to spend. So where should that $11,000 go? Well, it depends on your priorities. What's most important to you? Do you want to have those student loans paid off earlier? Great, put that extra $11,000 there. Now you'll have them paid off in less than five years (and can redirect that $11,000 elsewhere at that point, putting it toward your next most important goal).
So when people ask me these sorts of questions, I can't answer them. I don't have the information. Not only do I not know what their goals are (and who are we kidding, most of them haven't bothered setting goals or writing down any kind of plan), but I have no idea how they prioritize those goals. See the problem? I mean, I can give you an answer. I can tell you what I would do. But it has little to do with interest rates, tax-protected account contribution limits, or expected investment returns. It is all about your goals. So what if you can only get $35,000 into a 401(k) and a Backdoor Roth IRA? If your plan is to put $53,000 into retirement, the rest still must go toward retirement, even if it must be invested in a taxable account. If your plan is to put $5,000 a year toward a college education, it doesn't matter that you can put $15,000 into a 529 account. You're still only going to contribute $5,000. If your plan is to pay off your student loans within five years, it doesn't really matter whether you can out-invest the interest rate on the loan.
You Need a Plan
But wait, there's more. Prioritizing goals gets even more complicated when you consider some other things. For example, let's say you want to save up for the college education before you ever start putting extra on the mortgage. Well, you can do that. It might even come out ahead mathematically if the after-tax investment return on the investments is higher than the after-tax interest rate on the mortgage. But I would start with your goals and write down your plan. Once you have saved “enough” (either total or for the year) toward a goal, you can move on to the next one, according to your priorities.
An additional complication is that it is extremely unlikely that your income will remain static over the years. For many people, income rises. They get a raise. They make partner. Production goes up. The business becomes more profitable. They hire associates. Whatever. But if you have prioritized your goals, you can direct the additional income toward the most important one (and probably spend some of it, too). In fact, if you wish to spend more money, knocking off a goal (student loans, mortgage, college, etc.) can psychologically allow you to then spend what had been going toward that goal.
For other people, income falls. Maybe they are so burned out they have to cut back to part-time. Maybe they want to go on “the parent track.” Maybe a pandemic hits. Who knows? Having your financial goals prioritized again allows you to TAKE from the least important ones first.
For example, if I had to prioritize the above goals, I would do so in the following manner:
- Retirement Savings
- Student Loans
- College Savings
- Extra Mortgage Payments
If my income dropped substantially, I'd quit paying extra on the mortgage. Then once that income was used up, I'd stop saving for college, even if it meant not getting a state tax credit. Then, I'd quit paying extra on my student loans. Then and only then would I start saving less for retirement. But long before I got there, I would probably be canceling vacations, taking the kids out of competitive sports, and not going out to eat. However, there is nothing magical about my priorities.
Personal finance is both personal and finance. This is about your goals and your priorities. I suggest you prioritize your own financial goals and use that priority list to guide you when you either have more money than expected or less money than expected to put toward your goals.
What do you think? Do you have a plan you follow for prioritizing your goals? How do you decide what is most important? Comment below!
This hits the nail exactly on the head! Setting goals and priorities is the first step. Once this is done all of these seemingly tough this vs that questions become easy to answer. The answer lies within and no one else can give you that answer.
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Awesome post! Love the calculations. Thank you
I love this post and the calculations. Can anyone answer for me why he says he uses 5% real expected return for calculations that are many years down the road? Thanks. I play with these calculators sometimes to get a sense of how much to save for the next 20 years and I’d love to hear some reasonable/conservative estimates for returns.
Thanks!
Alex, historical averages of nominal market returns have been a little over 9%, however, the real expected return is adjusted for inflation. Given that inflation rates are approx 2.7%, let’s say 3%, we would expect to get returns in the 5-6% range. My IPS is written with the expectation of 6% based on my asset allocation of stocks to bonds, market volatility, and said inflation rate. This is a hopeful estimate/prediction. Either way, the use of 5% is a good conservative estimate and may reflect the expectation that stocks and interest bearing investments may offer reduced returns given factors such as future economic growth/GDP, future dividend yields, interest rates and market valuations.
Two ways people tend to make this estimates/guesses:
#1 They take long term historical returns and assume future long term returns will be similar. So they project the past into the future. So if you assume 10% returns from the stock market, 5% returns from the bond market and a 50/50 mix, you would expect returns of 7.5% If you then subtract out historical inflation of about 3%, you’d end up with 4.5% real returns.
# 2 They take current valuations and yields and assume they will continue going forward indefinitely. These would suggest even lower returns for stocks and bonds.
My portfolio is more aggressive than 50/50 and includes more than the US stock market and the US bond market so I think I’ll do a little better than someone with a 50/50 portfolio. So I use 5% real.
Thanks for the response!
The fun part about calculations is that they’re highly dependent on the inputs. Garbage in, garbage out. But you get to decide what your inputs will be. If you think 5% real is too high or too low, then use whatever number you prefer your calculations. My crystal ball is certainly cloudy about my future portfolio returns. But I can tell you my past returns over the last 16 years are 14.95%, so something like 12-13% real. Now that’s HIGHLY dependent on great recent returns. A couple of years ago that number was only 6-7% real.
I can’t tell you what to use your own calculations, but most people who try to estimate future returns in a reasonable way will come back with a range of potential long-term future returns and 5% real will be within it.
It’s posts like this that keep me coming back. Thanks for the super simple approach to what seems like a stressful topic….but isn’t (or shouldn’t be). Bonus points for providing the calculations!
Yea, I’ve learned to include them because I always have people ask 2 years later how to do them and I have to recreate them. Easier to just show my work.
Jim,
Great article, but the math is off by quite a bit. After working with lots of people one-on-one to help them reach these same goals, most people make the same two mistaken assumptions found in this article and it throws things way off.
#1 There is a big difference between calculating an annual payment vs monthly payments. In real life they will be making monthly payments. That means they will be compounding monthly, not annually. In your Student loan payment for example, the annual payment calculation is $34,169. But if you used a monthly payment plan you would pay $2,796.45 a month which is $33,557.40 a year in payments. That difference is $611.60 per year or 1.82% off. That is happening for each of the goals. If someone was over paying a broker by 1.8% in annual fees, you would say that is a big deal over time. And it is.
#2 You neglect the snowball effect. For example, you are paying off the student loans in five years but fail to account for that money after that. In reality, once the student loans are paid off, there is an extra $33,557 a year to go into their goals that is no longer used for their student loans. That is a very large chunk of change.
So I did the calculations using the following plan. I took the $88,751 ($7,395,91 a month) that you said they can afford and used it in the following manner with all the same balances interest rates you mentioned.
Max out the 401(k) at $19,500 a year or $1,625 a month
Max out two Backdoor Roth IRAs at $12,000 for the year or $1,000 a month
Pay nothing to the 529 plans at first.
Make no extra house payments at first.
That leaves $4,770.91 for making other payments and investments.
Start with all of that going towards the student loans beginning Jan 2021. The student loans will be paid off by November 2023 (less than 3 years)
Then transfer the $4,770.91 a month to the first 529 plan and make 12 deposits until November 2025. There will be $58,581 in the plan that will continue to grow at the 5% you suggested which reaches $100,580 by Sept 2035 when the first child enters college 14 years from now.
Then start making deposits into the second 529 plan also for 12 months. By November 2025 there will be $58,581 in the account. It will continue to grow at 5% until September 2037 when the second child enters college with a balance of $105,726.33. (It got an extra year to grow over the first 529)
This means the first three goals are achieved by less than 5 years of payments, which was the original goal for the student loans alone.
Next we will add the $4,770.91 as an extra payment to the $2,245.22 regular house payment. Thus on December of 2025 the house payment bumps up to $7,016.13. By now the outstanding balance has dropped to $450K from the last 5 years of payments. The house will be paid off in November 2031, nine years ahead of their goal. After ten years they are debt free and college is funded for both kids.
Now they add the $7,016.13 they were making in house payments to their savings to augment their retirement accounts. By the time they reach age 60 in Jan 2046 they will have a balance of $3,293,589. Just shy of their goal. If they keep working for another 2.5 years, at age 62 on June 2048 they will have $4,012,205 in savings.
If they were to put approximately $1,000 more a month into this plan at the start, bumping up to about $100,000 a year, they would meet all their goals. That is about $35,000 a year less than the calculations you propose would be to meet their original goals. They can come darn close to all their goals at the $88,000 a year you propose they can afford.
Hope this helps to illustrate the power of the snowball method by concentrating on one thing at a time instead of trying to do everything at once.
Dr. Cory S. Fawcett
Financial Success MD
This is outstanding. I was going to make a separate comment but I think I’ll just reply to you instead and ask my question. I’ve been at this about 2 1/2 years post training and have a fairly similar scenario to what is illustrated here. Higher income, but also higher debt and higher expenses.
The question that I have is something I have struggled to understand, and that’s inflation. Can you help me to understand this 5% “real” thing. Is it as simple as we’re hoping for an 8% return but subtracting 3% due to inflation? If I want $4 million in today’s dollars at retirement (id actually prefer 5) how much does that mean I will need to actually have at retirement? 80,000 per year is kind of my goal right now but that should get me well over 5 million with decent returns in 25 years.
Kevin,
Inflation is a real thing, just like market return. But in both cases we don’t know what it will be and it is only a guess. Your simplification of “real return” is just as good as any other. Having $4,000,000 in retirement is a draw rate of $160,000 a year before taxes using 4%. You will also have social security added to that. If you are debt free, you should be able to live a great retirement life on that.
Best of luck,
Dr. Cory S. Fawcett
Financial Success MD
Yes.
If you think you’ll see 3% inflation going forward and you want to know what $4M in todays money will be in 20 years, you simply use a Future Value calculation:
=FV(3%,20,0,-4000000) = $7,224,444.94
You state the math is off, that’s not true.
What I think you meant to say is that I should have used other assumptions. That’s your right.
I do agree that if whatever was going to one goal is redirected to a second goal as soon as the first one is met, then you will reach that second goal faster than planned. That’s quite obvious. But if you spend that money instead (as many do) then it won’t speed up the time to reach the second goal. Again, quite obvious.
Which one most people are likely to do, I don’t know.
Jim great post as always. I see the question of “Pay off debt vs invest” as a dilemma between what is optimized mathematically, and what behaviorally feels good. That is the real question at least for me, and I think deep down that is what drives this question of pay off debt and invest for everyone. It’s math vs. behavior, and when behavior goes against math, people are asking you and other financial authorities which should I choose.
So in my financial plan I focus on not the question of “pay off debt vs invest” but rather “optimized vs feeling good”. I do hate debt, don’t get me wrong, but I hate not being not mathematically optimized even more! so my written financial plan says to invest and not payoff debt. Jason Zweig has convinced me never to trust your gut when it comes to investing, but I think for me this includes whether to pay off debt or invest. I am using my reflective system and frontal lobes and I am investing. But at least to those who want to trust their amygdala/nucleus accumbens when it comes to paying off debt, the reactive system choice is not a bad one!
Make sure you adjust for risk and hassle and utility of additional wealth in your mathematical optimizing. I carried debt until I was 11 years out of residency. But I don’t anymore. It is not longer worth the additional risk and hassle to me and there is very little additional utility in additional wealth for me.
Thanks for this post. I have set goals for myself and have been fortunate enough to surpass them as my physician income grows. I am now at a point where I decide between additional retirement savings or extra mortgage payments. I have started to believe in the concept of making the extra mortgage payments instead of adding more bonds to my retirement portfolio, thereby skewing my asset allocation. I figure I am young enough (40) and liquid enough, and can rebalance with more bonds after my mortgage is paid off. What do you think about this strategy?
Doesn’t seem crazy. A debt is just a negative bond.
Great content, but I gotta say, lately the White Coat brand has really suffered from some of your “disciples” elsewhere… No offense, I of course think youre a smart guy. Alsmot like you should just stick to the blog and books, and pull the plug on all these bitcoin/politics/rumor/conspiracy crazies on the social media! You’d think these people never even read your primary material about NOT picking stocks or gambling with crypto-currency! Sickens me to think of all the doctors who might be led astray from these foolish people.
I like to think of these crazies as preventing me from confirmation bias, but also those are the people that need to be educated in not doing BTC or individual stocks. I agree with you that their is a risk of docs being led astray by these foolish people, but I think there is worse risk in letting these people “teach” wrong financial principals in social media that do not have the WCI community to correct them.