Why Paying Off a Loan Early May Cost More Than You Think
Key Takeaways
- The Two Doctors in Debt scenario illustrates the financial tradeoff between saving interest and accumulating wealth over the long term.
- The 3-to-1 wealth accumulation point is reached when every $1 invested has the potential to generate $3 in future wealth.
- For low-priority debt, prioritizing savings and investments over accelerated repayment may lead to better long-term financial outcomes.
For many people, debt feels like the enemy. After years of student loans, practice financing, mortgages, and equipment purchases, the instinct to eliminate debt as quickly as possible is understandable.
Making extra principal payments on a loan feels responsible. It reduces interest, shortens the loan term, and provides peace of mind.
But what if aggressively paying down low-priority debt actually left you with less wealth over time?
At Cain Watters, we use what we call the Two Doctors in Debt scenario to illustrate an important financial principle: the difference between saving interest and accumulating wealth. CWA Planner and CPA Ben Svoboda walks us through the finer points of this important concept.
Case Study: Two Doctors in Debt
Imagine two dentists who have similar practices, incomes, and cash flow needs.
- Each doctor finances $200,000 over 20 years at a 7% interest rate
- Both share the same goal of saving $2,000,000 at the end of those 20 years
Doctor 1 puts $2,500 toward the principal balance every month. The loan is paid off years ahead of schedule, saving thousands of dollars in interest. However, that $2,500 a month actually costs $4,800 a year when taking into account the tax spiral. More on that later.
Doctor 2 makes only the required loan interest payment and invests an equivalent $4,166.67 every month into a tax-deferred vehicle (IRA, 401k, etc.) with a diversified portfolio designed for long-term growth.
At first glance, Doctor 1 appears to be making the more responsible choice. But 20 years later, Doctor 2 often ends up with the larger net worth. Why?
Because while Doctor 1 was eliminating debt, Doctor 2 was accumulating wealth.
The Difference Between Interest Saved and Growth Earned
Paying extra toward a 7% loan provides a guaranteed 7% return, as every additional dollar eliminates future interest charges. That’s certainly valuable.
But over long periods, diversified investment portfolios have historically generated returns that exceed the interest rate on many practice loans and mortgages.
So even if your investments earn 8% while your debt costs 7%, your money is effectively working harder than it would if eliminating debt. Even better, it’s earning something that debt repayment never will: compounding growth.
Think about it this way. Instead of every extra dollar working only once by paying down debt, that same dollar can continue working for decades, earning returns, generating additional earnings on those returns, and allowing compounding to accelerate over time.
This result is what we refer to as the 3-to-1 accumulating wealth concept — that magical point where every dollar invested earns $3 in interest. Once you reach the 3:1 return ratio, continuing to invest becomes optional, because your compounded money is working so hard that additional dollars won’t significantly raise the total saved.
It’s a great place to be, but the key to reaching it is time. At an 8% annual return, it takes just over 18 years to reach it, which is why Doctor 2’s wealth accumulation strategy paid off.
The Hidden Cost: The Tax Spiral
Another cost of accelerating debt payments that often goes unnoticed is the tax spiral. Let’s go back to Doctor 1, who is paying $2,500 a month ($30,000/year) to principal. That money doesn’t come from pre-tax income. It comes from money left over after taxes have already been paid.
Assuming taxes on $30,000 are around $12,000, he needs to earn an additional $12,000 to make up for it, which then would require $4,800 more in taxes, which requires $1,920 — and the spiral continues. In the end, Doctor 1 must earn $50,000 to pay $30,000 toward the principal, creating a cycle of playing catch-up each year to pay the prior year’s taxes.
As Figure 1 shows, every extra dollar applied to debt requires substantially more than a dollar of production as the tax burden spirals.
The Results: 20 Years Later
Doctor 1 paid off his debt in six years and immediately began investing the total amount he had been putting toward the loan for the next 14 years. He ended up just shy of the savings goal at $1,969,439.
Doctor 2 continued to invest at the same steady rate. In year 20, she used a portion of the income earned to make the $200,000 loan payment. Even with a hefty one-year debt expense, she far exceeded the goal, earning $2,816,792.
The initial six years of compounding put Doctor 2’s money on the path to 3-to-1 wealth accumulation, while Doctor 1’s investment never quite reached this important milestone. This underscores the importance of time and consistency in creating a retirement “snowball” that grows exponentially faster.
The Cain Watters Perspective
While a somewhat extreme example, the Two Doctors in Debt scenario highlights how building wealth isn’t about becoming debt-free as quickly as possible. It’s about putting every dollar where it has the greatest opportunity to work.
As always, the most effective strategy depends on your interest rate, expected investment returns, tax situation, cash flow needs, risk tolerance, and overall financial plan.
Ready to see if your money is working as hard as it should? Talk to a CWA advisor about your professional and personal goals as you work toward financial freedom. Set up your free consultation today.
IMPORTANT NOTE: Not all debt is created equal. This strategy is designed only for addressing low-priority debt, like student loans, practice loans and even some home loans. High-priority debt like credit cards, auto loans, and credit lines should always be addressed with priority.
