Last week I read this post by The Prudent Plastic Surgeon, which starts out calling a savings rate of 20% “pretty much mandatory” for building wealth. I think this is a fine goal. He writes that paying down debt should count, as it improves your net worth (which it does).
I wasn’t so sure. After all, if your plan relies on saving and investing 20% of your money for 30 years in order to build up your nest egg, then using some of that money to pay off debt should, in theory, mean that you come up short.
As I was walking this weekend, I was thinking about this more and more, and was getting more and more annoyed. I figured it was time to bring out the numbers and see how this worked.
Our test subjects will all be 30 year old internists, married with 2 children. They rented for the first year at their job, paid down any consumer debt they had, cemented their emergency fund, and made sure they were in their forever practice. Then they bought their forever home.
Each family makes $250,000 before taxes (that seems high to me, but it was referenced in PPS’s post as the median physician salary), have $200,000 in student loans (refinanced at 3%) and a doctor mortgage of $500,000 for the house they just bought (30 year loan, fixed interest, 3.25%. Note house costs the recommended 2x yearly salary ). Their investments will earn 5% after inflation. They have an adequate emergency fund, and have no debt other than the student loans and mortgage.
Let’s see how they do following a 20% savings rate, applying their savings to debt pay off and investments in various combinations.
Johnny Hates Debt
Johnny hates debt. I mean, he HATES debt. He decides that he is going to pay down his student debt with all the money put aside for savings ($50,000 per year). When that loan is done, he will apply his student loan payment, and the $50,000 a year, towards his mortgage. Only then will he start to invest for retirement (or wealth building).
How does this work out for him?
As you can see, his student loans are paid off in 3 years, and his mortgage in 9. Debt free by 39–pretty impressive. He also starts investing that year, and has a little less than $80,000.
He had a required monthly student loan payment of $1,931, and a mortgage payment P&I (principal and interest) of $2176. Once the loans are gone, he will invest all that money, $4107 per month, plus $50,000 once a year. Please note that means he is actually investing $99,284, or nearly 40% of his gross income.
By the time he is 60, he should have about $2.2 million in investments, which, if he spends 4%, should net him $88,000 a year. Between taxes and savings, that’s probably pretty close to what he has been living on all this time (see the last section), and he might consider retiring a few years early.
Jill Splits the Difference
Jill isn’t all that fond of debt, but she also feels it’s important to invest. She splits her 20% savings evenly between paying down debt and investing. Every year she applies $25,000 towards her debts, and $25,000 into investments. Once she pays off her student loans, she applies that payment towards her mortgage as well.
How do her finances stack up?
She lags a little behind Johnny, and needs 5 years to pay off her student loans. Her mortgage isn’t gone for another 7 years, making her 42 by the time she becomes debt free.
However, by that time, she already has over $450,000 in investments.
Over the next 18 years, she adds what she had been paying towards debt to her investments, so she also invests a total of $99,284 per year, or nearly 40% of her gross income.
By age 60, she will have just a little more than Johnny saved, about $60,000. Nothing to sneeze at, but her nest egg will generate a very similar amount for her when she chooses to retire.
Jack Gives Himself a Raise When He Pays Off Debt
What about Jack? Jack diligently saves 20% of his income, or $50,000 a year. However, when he finishes paying off a loan, he rolls the payment into his monthly spending and enjoys the “raise” he gets. He is saving 20% of his income, and not a percentage point more.
He pays off his student loans by age 33, and his mortgage by 40, making him debt-free. Very nice.
He then invests his $50,000 a year, and by age 60, has an account worth $1.7 million. Not bad, but $400,000 to $500,000 less than Johnny and Jill. Using the 4% rule (because he isn’t going to retire all that early), his nest egg would generate $68,000 a year.
He has been spending quite a bit more, probably more than twice that (see below). Maybe he’d better work a little longer. By my calculations, he’ll need to work 10 more year, until age 70.
Ingrid Invests
All this makes me wonder about Ingrid, who decided paying off low interest debt is a sucker’s game. She took 10 years to pay off her student debt, and 30 years to pay off her mortgage. She had debt payments until she was 60. Ugh.
However, she put all of her $50,000 into investment accounts for 30 years. Once she retired her mortgage at age 60, her investments were worth a whopping $3.5 million. If she wants to retire on 4% of that, she’ll be enjoying an income of $140,000 a year. Now that her mortgage is paid off, she could retire and have more cash to spend each month than when she was working.
Assumptions
All of these scenarios depend on a number of assumptions:
Our doctor stays at the same job, and earns exactly the same amount of money (indexed for inflation) for 30 years. No bonuses, inheritances, lottery wins. Also no pay cuts, unpaid leave, job loss.
Each doctor follows the plan slavishly: Jack never saves anymore than $50K a year. Jill never splurges when she pays off a debt, and Ingrid never puts any extra money into debt repayment.
The interest on their debts–student loan and mortgage–is lower than their investment returns. After all, it would be silly to keep a mortgage at 12% if you were making only 5% on your investments.
Most importantly, the investments churn out a 5% annual return every single year, which is totally unrealistic. A few good years, a few bad years, distributed unequally throughout our 30 year timeline– these can make a huge difference in how much money our 4 doctors end up with.
Caveats
If there is a huge bull market at the beginning of their careers, Jill and Ingrid will totally outpace the boys. A flat or declining market in those early years with a bull later could make the differences between investing plans quite slim.
We also don’t account for the emotional effects of paying off debt early.
Maybe Ingrid doesn’t mind paying over $4000 per month in debt repayment for 10 years. Or maybe she starts to feel burnt out and feels the last 10 years of her career are a total grind.
Perhaps Johnny feels such freedom from being debt free that he feels empowered to change jobs; he could start a direct primary care practice, and end up happier in his job. He might even happily keep working into his 70s, because of the fulfillment he gets through caring for his patients.
A Side Note on Taxes, Annual Spending, and Nest Eggs
For those interested, I used a paycheck calculator to estimate taxes for our doctors, assuming 4 people in the family, no pretax retirement contributions (a bad idea! But it helps simplify the numbers).
In Walla Walla, WA, a state with no income taxes, Jack would be paying $57,648 per year in taxes; in Eureka, CA, a state known for significant taxes, Ingrid would be paying $76,488 yearly.
This suggests Jack would be living on about $142,000 a year, and Ingrid $123,000. John and Jill would be living on $77K to $93K, depending on their state of residence.
My Thoughts
My original beef was comparing Johnny (pay off all debt first) and Jill (split the difference). I thought for sure that Jill would come out ahead because of the power of compounding. However, Johnny is investing a ton of money between ages 39 and 42, enough that he pretty much catches up by 60.
We can also look at their investments and their yearly spending, and see that one is about 25x the other. They are [probably] all set for a comfortable retirement after 30 years.
However, what I really take away from their examples is that, although they started by saving 20% of their income, they did not inflate their lifestyle once their debts were paid off. Instead, they increased their savings rate to ~40%.
Ingrid does OK for herself as well. She invests 20% of her income every year, and although she carried a bunch of debt for decades, by the time she reaches 60 she is more than set. She will have plenty of money to support herself if she chooses to retire.
Poor Jack, though, he stuck with the 20% rule and figured that was enough. He kept investing his money once debt was paid off, but increased his lifestyle to match his higher disposable income. At the end of 30 years, he still doesn’t have enough put away to support himself in the style to which he has become accustomed. He will either need to pull back on his spending, or work another 10 years (maybe less if he counts Social Security).
Are you saving 20%? More? Less? Do/did you plan to save your “raises” when you pay off debt, like Jill, or spend them, like Jack?