Should You Invest or Pay Off Your Debt?

Last updated on July 22nd, 2017

A close friend of mine asked me the following question: “My wife and I both have some student loan debt and a mortgage, but we would like to begin investing. Should I prioritize paying down the debt, or investing?”

This is a common question, and many blog readers struggle with making a similar decision. My answer was not straightforward, because there are several different possible solutions that depend on personal preference.

  1. The rational answer is to choose the option with the highest expected payoff. More simply, choose the option with the highest interest rate. If your debt interest rate is higher than the expected return from investing, pay off the debt first. If the opposite is true, pay the minimum amount each month on the debt, and invest the rest.
  2. The behavioral answer is more complicated, because debt carries an emotional cost. If you despise debt, you might prefer paying down the debt regardless of the interest rate.
  3. Or, consider a hybrid approach where you invest and pay off the debt simultaneously.

If you desire a more detailed approach, continue reading.

1) Automate Minimum Payments

When dealing with any type of debt, the first step is automating minimum monthly payments. Doing this prevents late payment fees and other penalties.

Set these payments up through your bank account, or directly with each creditor.

If you are having trouble staying current on all of your debts, consider consolidating or restructuring your debt.

2) Create Liquidity (an emergency fund)

You want to set aside cash in a liquid checking or savings account that is easily accessible. The common recommendation is to set aside enough money to cover 3-6 months of expenses, but choose an amount that makes you comfortable.

This money prevents you from accumulating more debt in an emergency situation.

3) Take Your Employer Match

If you have a retirement plan at work, does your employer offer to match your contributions? If so, then you should participate and take advantage of that free money.

An employer match typically looks like this:

You’re earning $50,000 per year. If you contribute 5% of your pre-tax income to the 401(k) at work, you will have set aside $2,500 for the year.

If your employer offers a 1:1 match, they also set aside $2,500 on your behalf. Your total account balance is now $5,000. That’s a 100% return on your investment, with zero risk.

Even if your employer only matches half of your contribution, that’s a 50% return. You cannot beat an employer match, because it’s risk-free money.

The one caveat here is your employer’s vesting schedule. Some employers require that you work a minimum number of years before the match money is legally yours. You need to check your plan to view the vesting schedule.

4) Pay Off High Interest Debt

Some forms of high-interest debt should be prioritized before investing. For most people, this includes consumer debt (such as credit card debt) and unsubsidized student loan debt.

If you are wondering why I recommend prioritizing the debt, consider the following reasons:

  • Most experts are expecting less favorable investment returns in upcoming years. Stock valuations have climbed much higher than the historical average, which is expected to reduce future returns. Furthermore, bond yields are near all-time lows, and interest rates are expected to slowly trend upward. This combination could result in a low-yield environment for many years. In such a scenario, expect a balanced portfolio to yield much less than the historical average (5-6% is a common long-term estimate).
  • Investing in financial markets involves much uncertainty, and there are no guaranteed returns. Most financial assets are risky, and the stock market can be extremely volatile in the short term.
  • Paying off your debt is a guaranteed return. If your debt carries a 9% interest rate, repaying the debt results in a guaranteed 9% return.

When deciding between debt repayment and investing, you should compare the expected return of each. Because debt repayment provides a guaranteed return, you should compare against a “guaranteed” investment, such as a short-term bond or savings account.

Treasury Bonds are often considered the “risk-free” asset because they are backed by the U.S. Government. Short-term bonds are much safer than long-term bonds because of interest rate risk. As interest rates rise, the present value of a bond falls. So a fair debt comparison might be a short-term Treasury Bond or savings account.

A high quality savings account yields about 1% in our current environment. A 1-year Treasury bond yields less than 1%. Even riskier bonds (such as the 10-Year Treasury) are yielding less than 2.5%. That’s a scary low yield for a 10-year investment.

As you can see with the numbers above, no investment in our current economic environment is going to offer you a guaranteed return in excess of 5%. As a result, I think 5% is a reasonable estimate for “high interest debt.” You might disagree slightly with the numbers, but you should view your debt as a guaranteed return when making relevant comparisons.

For the more technical readers, you should be comparing the after-tax return of both options. Some forms of debt (i.e. mortgage or student loans) are tax-deductible, lowering the effective interest rate. Unless held in a tax-sheltered account, most investment income is also taxable, lowering the after-tax yield.

For example, let’s assume you are in the 25% tax bracket and itemize your tax deductions. If your mortgage carries a 5% interest rate, the after-tax rate is 5% – (25% * 5) = 3.75%. If you invest in a savings account offering 1%, your after-tax yield is 0.75%. The difference between the nominal rate and effective rate increases with your income tax bracket.

5) Decide How to Handle the Remaining Debt

Above, I suggest 5% as a reasonable estimate for high interest debt. If you disagree, you need to identify a reasonable estimate for your situation.

At the other end of the spectrum, some debts carry very low interest rates. If the rate is below 2-3%, you might consider retaining the debt and investing instead. This is especially true if you are able to make additional contributions to tax-sheltered accounts.

Debts that carry an intermediate interest rate (in my example, between 3-5%) are a matter of preference. In such a scenario, choose what makes you happy. If you like the idea of being debt-free, pay off the debt. If you feel indifferent, split the difference.

Summary and Conclusions

The steps outlined in this article can help you decide between investing and paying off your debt. You might disagree with my definition of “high interest” or “low interest” debt, but that’s a matter of personal preference.

In the end, the optimal decision is a function of your rational and behavioral preferences. The rational decision is the one with the highest expected payoff. The behavioral decision is the one that makes you happy.

How are you approaching this decision? Share with a comment below.

Comments
    • Cate
    • March 22, 2017
    Reply

    I agree with your points. One area I struggle with is paying off the mortgage. Online opinions seem to widely vary on whether it makes the most financial sense or not. Seems to be more of a personal choice. But so far I prefer to keep a mortgage, maybe because I don’t plan on staying in my current house forever.

  1. Reply

    I definitely agree with getting at least the match from your employer and then tackling high interest debts.

    My auto loan is 2.24%, but I’m going the emotional route with it and paying it off early. I’m still investing a small amount. It was a hard choice to make because I know with that interest rate being so low, the math says invest for a greater return. I’ll just be a lot happier once it’s completely gone and then I can focus solely on building a bigger nest egg.

    Great article and breakdown! It’s been a question I’ve struggled with for quite a while on what to do.

  2. Reply

    Nice article! I paid off debt before I invested, and in hindsight, I should have invested as the market has done well while my refinanced student loans were at like 4% interest. But, you can’t focus on hindsight I guess…
    Also, there’s something very emotionally satisfying about paying off debt. I’ve seen my investment portfolio grow to be way more than my debt ever was, but paying off the debt was a huge boost for my financial motivation and overall wellbeing in life. I’m usually the one to chant the “rational investing” mantra, but depending on your personality, paying off the debt might be an overall better move.

  3. Reply

    Great article on a issue that many young / beginner investors struggle with. I agree that you should pay off high interest debt before you start investing. Even some of the more experienced investors would have a hard time generating a return that is greater than the average interest rate charged on credit cards. In addition to what you discussed above, I wrote about two common methods used to pay off debt in my blog. These approaches are typically referred to as debt snowball vs debt avalanche. Both methods can be used to reduce debt either before you start investing or when you beginning investing.

    Thanks again for a great article. Looking forward to reading future posts.

    • Greg
    • February 4, 2017
    Reply

    Great article, especially for beginners trying to figure out how to get started. I attacked #2 and #3 simultaneously, putting some money away in an emergency fund while ensuring I got the free match from my employer. And I agree that you have to try and put emotion aside… I so wanted to pay off my car early, but knew that I was getting the better deal by investing the extra money instead. Thanks for the good thoughts!

    • Michele Cooper
    • December 30, 2016
    Reply

    I have more of a behavioral approach and consider paying off debt before thinking of investing. I agree on taking the employers match, contribute as much as possible to it and take advantage of it. I think the decision usually depends on your financial situation. You need to keep financial goals and then evaluate your investment options.

  4. Reply

    Exactly, I agree. Get rid of the high interest debt. Maximize your employer matched retirement plan; and when you’ve accomplished the above…then start investing. Good article.

  5. Reply

    Hi Cash Cow Couple,
    Thank you for writing this article. I really like how you separate the issue of paying down debt vs investing into rational and behavioral levels.

  6. Reply

    Assessment of the two should be done because I think the answer to this question or dilemma is situation based. Both emotional and financial aspect should also be taken into consideration in making which one to prioritize. Personally, I’d do investing while paying off debt at the same time.

    • Kelly
    • November 26, 2016
    Reply

    I myself decided to do it in a hybrid manner because it is something that works for me. I think people need to assess their needs and capability of which one is more important to prioritize. In my case, it’s both as it balances everything especially my emotional attachment to both.

  7. Reply

    I go back and forth on this issue endlessly. There is room for disagreement even among the most informed and intelligent folks, which is why this is such a tough question!

    I’m about to close on the sale of a condo and will net around $88K – almost exactly the payoff balance of another rental property mortgage which is fixed at 5.00% with around 23 years remaining. We are already maxing out all retirement accounts, so the question is whether to invest this money in taxable brokerage accounts, buy another rental property or some other investment, or pay off the other mortgage and boost our monthly cash flow as a result.

    I’m torn because stock valuations seem frothy, as do property prices in my area. But we are in the 33% tax bracket (28% some years but under Trump’s plan we’ll be firmly in the 33% indefinitely). So that 5% mortgage is more like 3.35% effectively. And with the Fed likely to raise rates in December and next year, it’s quite probable that muni bonds would return more than that in pretty short order.

    Then again, wiping out a whole mortgage and having a paid off rental “feels” good, and it’s simpler than constructing a muni bond ladder and monitoring interest rate fluctuations. There’s no wrong answer, but I’m sure I’ll go back and forth on this question for much of my investing life.

  8. Reply

    I subscribe to the pay yourself first way of thinking no matter what your debt situation. At the very least, I think you should be contributing enough to take advantage of any employer match you receive. After that, I agree with tackling your high interest rate debt first. If you have low interest rate debt such as a mortgage, I say let it ride and invest your money in low cost index funds instead of paying down low interest rate debt.

  9. Reply

    I like this. A very sensible discussion between investing and paying off debt. You have come up with a well considered comparison that I think uses realistic return/interest rates.
    Any further thoughts on bonds now that the price is starting to come down a bit? I am 100% into stocks and have avoided bonds as they haven’t seemed to make any sense to me (i’m only 34 anyway).
    Cheers,
    Paulie

      • Jacob
      • November 24, 2016
      Reply

      Hi Paulie,
      There is one thing that looks highly probable: bond yields are going to remain low for several years. No one can predict the future interest rate policies set by the Federal Reserve, but they are going to continue holding rates low for a while.

  10. Reply

    It’s both a personal and math problem. People handle debt differently in emotional terms. Am of the pay-your-debts first and then consider investing camp, (big Dave Ramsey fan too). But as you rightly point out, there are certain mitigating (and logical) factors that can make investing even with debt an option worth considering.

      • Jacob
      • November 24, 2016
      Reply

      Thanks for the comment Glenn.

    • Syed
    • November 23, 2016
    Reply

    Excellent breakdown on this thorny issue. I agree contributing to tax advantaged accounts should take priority, especially if you get a match. I ave a similar threshold of 5% so that would include pretty much all types of credit card debt. Get rid of that stuff ASAP!

      • Jacob
      • November 24, 2016
      Reply

      Thanks for the comment Syed.

 

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