When I started this blog, I emailed the first post to a handful of friends and family. I asked if there were any personal finance topics they wanted me to cover. There was just one topic requested by more than one person and it impacts most of us. The question is: should you use extra money to pay off debt or invest?
This question has many forms:
Should I pay extra on my student loans or contribute to my 401(k)?
Should I accelerate paying down my mortgage or invest in a taxable account?
Should I stop making 401(k) contributions to pay more than the minimum on my credit card bill?
You get the point.
I thought about writing a post on the topic and then… I waited. For this question, I didn’t have a definitive answer right way. At least, I didn’t have one that would apply to everyone. I finally figured out why. Here is my attempt to answer this difficult question and sort out the “pay off debt or invest” decision once and for all.
The solution is obvious: It depends. I know, I know. That isn’t what you want to hear. So let’s review some of the variables you should consider before making a decision.
What Are They Key Decision Factors?
The Interest Rate on your Debt
The interest rate on your debt should have a huge impact on your decision. I checked in (using a flawed poll) with my followers on Twitter to see what rate would cause them to invest before paying off their debt.
— WinningPerFinance (@WinningPFin) November 16, 2017
I was shocked at the results! Still am. 55% of those who replied said they would pay off debt over investing regardless of the interest rate! Frankly, I just don’t understand this logic.
Let me give an example of why. If somebody offered me a one year loan of $250K at 0.5% APY, I’d sign on the dotted line in a second. As of today, it looks like the going rate on a one year CD is about 2%.
The cost of the loan would be $1,250 in interest. You could take the loan money and buy a CD that would earn $5,000 in interest over the same year. At the end of the year you would pay back the loan and realize a pre-tax profit of $2,875 risk free. You may remember my post about how I’m done giving interest free loans. This is the opposite situation. When somebody is offering me an interest free (or low interest) loan, I’ll take it!
Credit cards actually do give interest free loans for a few days as long as you pay them in full each month. I wonder if the folks that said they’d “pay off debt at any cost” eschew credit cards completely. Or if they pay their bill the same day they use their card?
If you can earn a risk free return (after tax), that’s greater than the cost of your loan. Make only the minimum loan payments and earn something on your money! Doing otherwise is throwing money away and you know how I feel about that.
The Investments You’d Choose and their Expected Return
The next consideration is how you would invest. In the example above, the interest rate on debt was below the going rate on a risk free investment. Those situations are extremely rare.
If the rate on your debt is higher than your expected investment returns, your decision is easy: pay it off. Paying off high interest rate debt is like earning a guaranteed high return… risk free!
Now, for the fun part. What should you do if the interest rate on your debt is between the rate of a risk free investment and your investment’s expected return? It may be worth accelerating the debt pay off. Or you could be better off paying the minimum on your debt, investing the extra amounts.
A key consideration here is that return on most investments is not guaranteed. The historical return of the stock market is higher than current mortgage rates. Still, future returns are unknown. You need to consider if it’s worth taking on the risk of variable investments to earn a higher expected return.
Other Decision Factors
The two factors above should be a basic guide for the majority of pay off debt or invest decisions you make. However, there are other factors that are important.
This special circumstance is so important, I must point it out first. It’s essential to take advantage of free money when somebody is trying to give it to you. An example of this is a 401(k) match. If your employer is going to match your investment contribution, take it. You need to do anything possible to get that match.
A match drastically increases expected return. For example, my company matches 50% of my contributions into my 401(k) up to 6% of my salary. This means that on the first 6% of my salary that I contribute, I’m getting a 50% return guaranteed. That type of return is amazing. It’s better than you can expect to earn anywhere else [insert Bitcoin joke here]. The circumstances would have to be extreme to stop me from contributing enough to my 401(k) to earn a match. I’d definitely choose earning a match over making an extra payment on a 5% student loan.
The raw interest rates and investment returns described above don’t tell the whole story. You need to consider their after tax impact. Remember, not everybody is in the same tax bracket. Different investment accounts (Traditional 401(k), Roth, taxable) have different tax treatment. Not every investment type (bank interest, stocks, bonds, real estate) is taxed the same way. The interest on some debt can be deducted on your return as well. All these details matter when evaluating the key decision factors above.
Some tax questions to consider are:
Can you deduct the interest you are paying on debt? If so, can you deduct all of it or are you only receiving a benefit from a portion of it?
What is your marginal tax rate today for your investment choice? For your (potential) interest deduction?
What do you estimate your tax rate to be when you have to pay taxes on your investment gains?
Your final decision on whether to pay off debt or invest should be based on the after tax impact of your choices.
When you pay a debt off in full, you are reducing a monthly expense obligation. Doing so may free up some cash flow and give you more options. Depending on the value of those options to an individual, it MAY – on occasion – be worth paying off a lower balance lower rate debt before a higher rate one.
When you accelerate payment on large debt, without having it fully paid off, you lose access to that money. This actually causes you to lose options. An example of this would be making an extra mortgage payment when you have $300K and 25 years outstanding on your loan. Sure, the extra payment will shorten your time to pay off the debt. Still, you will not see the cashflow benefit of it until the whole loan is paid off.
When you take an investment route with extra cash, you will still have access to it (less any taxes or penalties for withdrawals from a retirement account).
Sometimes “sh*t happens.” You never want to be in a position where you can’t pay your bills. Deciding to pay off debt or invest based on your liquidity or cash flow may have benefits that supersede the interest rates and expected return. It’s key to have a plan if you need money due to an emergency.
This site is “Winning Personal Finance.” It’s not called “How to do Personal Finance Math.” It’s possible for the math to point you toward one option. But a different choice may reduce your stress and increase your happiness.
I operate under the assumption that we all have a goal of maximizing our happiness. So, some people may choose to pay off debt when the math says to invest. This could reduce stress and maximize life satisfaction. In my mind, the focus should be on carefully considering your choices and making a reasoned decision. If you have and still prefer sub-optimal mathematical decisions, it may be the right life decision. Please, please, please make sure you’ve considered the math first though.
There are plenty of happy and successful people out there that chose to pay off a low interest mortgage. Many did so before investing in the market. I bet they’re happy to be living mortgage free even if a different choice would have padded their net worth a little more.
On the other hand, some people (like myself) are willing to take on risk and focus on making optimal mathematical decisions. This will, in theory, maximize net worth while reducing the time it takes to reach financial independence.
Your age and overall position can have a huge impact on your pay off debt or invest decision. When you are younger, you may be willing to take on more risk to chase higher returns. When you are older and have what you need to retire, you may be playing a risk reduction game.
Say a 22 year old and a 65 year old have the same low rate on their mortgage debt. The 22 year old may choose to make minimum mortgage payments and invest for the long run. The 65 year old may choose to use every available dollar to pay his mortgage and reduce sequence of return risk. Both of these decisions could be ideal for that individual’s circumstances.
Big ERN works in asset management and writes over at Early Retirement Now. He recommends that retirees pay off their mortgage. He also says pre-paying a mortgage is a bad idea for somebody in the accumulation phase. This is a smart guy giving different advice to people at different stages in life. Yet, it makes perfect sense.
Some people are more motivated to pay off debt than to invest. If you are one of those people, it may pay to ignore the math when after tax rates are close.
Say you have $2,000 each month to put toward debt or investments. You may know yourself well enough to say you would pay off debt at a rate of $2,000 a month. Yet if you were choosing to invest, you may only invest $1,000, while spending the other $1,000 on comic books. That’s a big difference and should be considered when deciding on your goal!
Debt has a benefit in that it is a hedge against inflation. As prices increase in the future, your dollar is able to buy fewer goods.
For example if you can buy a loaf of bread for $1 today, in 20 years that bread may cost $2. Yet, your mortgage or student loan monthly payments would not have changed. Therefore, you are using less purchasing power to pay your mortgage in 20 years than you do today, even though the amount did not change.
If you are paying debt back in the future with less valuable money, you are in effect getting a discount on your payment. Over a long mortgage, this can be impactful. By prepaying debt – you miss out on that discount.
On the other hand, deflation would have the opposite effect but it’s less common.
Pay Off Debt or Invest – Clear as Mud
I know I promised you an obvious answer. And the obvious answer was that the decision depends on a variety of factors. I’m sorry if you feel a bit duped. Please forgive me. Over the next few weeks, I’m going to make this complex topic a little easier. I’ll be featuring specific “pay off debt or invest” decisions made in real life. Hopefully, reading about the influencing factors above and the decisions featured in future weeks will help guide you.
If you would like to ask me a specific question about your pay off debt or invest decision, you can reach me through my contact page here.
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