What’s The Real Value of a Dollar? It Depends on Whether You’re Paying Debt or Building Wealth

What’s the value of a dollar these days? Less than it was a couple of years ago, I imagine. But what I am talking about here is the value of a dollar not due to inflationary effects, but rather on where that dollar is being utilized– and how much it really costs you.

Let’s first look at paying off debt. For example, say you have $1.00 in credit card debt at 20% interest. In order to pay off that debt you have to earn money, pay taxes on your earnings, and then pay off the debt. For the sake of simplicity, let’s say you are taxed at a 20% rate. You will have to earn $1.25 to pay off that $1.00. ($1.25 x 0.8 =$1.00). So to pay off that one dollar now, you have to earn $1.25. Now suppose you put off paying that $1.00 for one year. At 20% interest you owe, one year later, $1.20. But to pay off that $1.20, you will have to earn $1.50 ($1.50 x .8= $1.20) one year from now to pay it off.

Now let’s look at building wealth. Suppose you put $1.00 into your 401k account. Since you won’t pay taxes on your contribution, that $1.00 only costs you $0.83 ($0.83 x 1.2 =$1.00) from your take home pay. So if you are building wealth with pre-tax dollars instead of pay off debt with post-tax dollars, it costs you 66% less to invest $1.00 than to pay $1.00 in debt ($0.83/$1.25 =66%). If you want $1.00 a year from now, it costs you even less, depending on what interest rate you receive over the course of the year. Let’s assume 7%. You only need to decrease your spending by $0.77 now to have $1.00 in one year ($0.77 x 1.2 x 1.07 = $1.00). So creating $1.00 one year in the future only costs you $0.77 now. If you delay paying off debt in the above example one year, it will cost you $1.50, or almost double what it takes to create $1.00. If you were to throw in an employer match to your 401k contribution, you are talking about an even larger difference.

(Now, I know I have not considered taxes when the 401k money comes out sometime in the future, but this example is to illustrate the difference in the price of debt (high) vs. investing, particularly over time. Even if you were to invest in a Roth IRA , to get $1.00 in a year at 7% would cost you $0.93 now, and be tax free, vs. the $1.50 for the $1.00 in debt if you wait a year to pay it off.)

These numbers show how much more it costs you to carry high interest debt and how it can actually cost less (to your take home pay) to invest, and should motivate everyone to pay off debt as quickly as possible, particularly non-deductible, high-interest debt, and begin investing. A great place to start is with pre-tax savings, to minimize the effect on your take home pay, certainly up to the employer match in a 401k if your employer offers one.