Should You Pay Off Debt or Invest? (It’s Obvious!)

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?

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.

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!

Pay off debt or invest

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.

Related Posts:
The Stock Market Will Always Go Up Over Time
Don’t Let Fear Prevent You From Winning
Super Coin Flip Risk Assessment

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.

Free Money

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.

Taxes

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.

Liquidity

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.

Emotions

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.

Time Horizon

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.

Discipline

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!

Inflation

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

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.

To be alerted of future posts including the real life decisions I mentioned above, join my thousands tens of subscribers and enter your email below:

28 thoughts on “Should You Pay Off Debt or Invest? (It’s Obvious!)”

  1. Nice summary, Jason. A number of good points captured.

    While not definite, I’ve found it usually comes down to mathematics vs. emotion. As you highlighted, maximizing happiness is key. For me, avoiding debt is huge; we did this when Mrs. went to grad school and opted to lower investments in order to avoid debt completely.

    Thanks for sharing. – Mike

  2. Well written summary! I like free money, that is what got me to invest in my kids education. Canadian government gives you 20% when you invest in an RESP (up to a max), why wouldn’t you take advantage of it?
    I did the calculations between investing and paying off my mortgage, there were just too many variables on the investment side so I paid off my mortgage. It does feel very liberating:) Even if the numbers were more favorable to investing.

    1. You guys in Canada seem to have a leg up on us. A 20% bonus for contributing to college savings. That would be sweet. It would probably reduce the student loan crisis a bit too.

  3. Bahaha, I love it! Like you’ve said here, it depends on so many factors. Debt is a wealth-destroyer and is generally a good place for people to start if they’d like to achieve FIRE. But you do need to invest at least *something* while you’re in debt. I’ve been doing this in the form of a Roth IRA, although most of our money still goes into debt payments. Just as long as you have something accruing when you have time on your side.

    1. Glad you liked it. It’s funny, I wrote this whole post and never even considered splitting any extra money to do both. Thanks for pointing it out. I tend to focus on making the best available decision and then go all in with it.

  4. Excellent piece! I think the reason we can have this conversation to begin with is because interest on debt is still at historic lows. Certainly debt at lower rates is more palatable than at higher rates. The biggest negative being that you might be tempted to take on debt for something you don’t need. We currently have a small mortgage ($850-900ish/mo including points and plugs) plus 2 small cars on low-rate loans, one not far from payoff. Part of the rate discount comes from having better credit scores, too, of course. We don’t carry any other debt, though. We may pay off the cars early — if so, that would be a good “blog challenge.” 🙂

    1. I agree that this decision is only hard because of the current low rate environment. As rates go up,the choice becomes more obvious. If I was to buy a car today I’d plan to do so with cash. If they then offer me financing at one percent…it would be awfully hard to turn down.

    1. So interesting to me when people choose to split their extra money between investing and paying off debt. Care to share more details?

  5. Thanks for mentioning my work! Great summary! There are only few (any?) absolute truths in personal finance. That’s why it’s so disturbing to see some advisers (Dave Ramsey, Suze Orman, etc.) recommend to pay down debt at all cost. There are so many tradeoffs and I think you listed them all!

    1. Thanks for the kind feedback ERN. It means a lot to me that you think I covered it right. Some of advice given by the “experts” you mention has always irked me. Sometimes it seems like they failed grade school math.

  6. Hey,

    I’ve switched from a pay down debt mindset to invest mindset at 25. I want to start building a great base for the future, and it will start with savings and investments

    The

  7. This is an excellent summary.

    Many people have such an allergy to debt, it often clouds their judgment and makes them work against their own long-term best interests. Which is fine, that happens. But it really gets me hot when I see these people advise others, maybe less “seasoned” personal financiers, to forego better options, like maxing out all tax-advantaged accounts. Giving up the “Uncle Sam match” is akin to having a pre-payment penalty on the loan; the effective interest rate rises the more you pay off! Plus you can never go back in time and fill up those time-limited buckets. Finally, you subject yourself to more “sequence of returns risk” because when you delay your accumulation phase of investments, compress them into a shorter time period, you need to get lucky that those periods are good markets. That’s a recipe for working forever.

    The response to this is always a nod to “psychology.” I recognize that our brains are not perfect and make it difficult to behave optimally at all times. But the antidote to suboptimal psychology is to *learn how to get around it*, not to submit to our evolutionary shortcomings!

    1. Trent – With a comment like that I feel like I should turn the whole site over to you. It captures the essence of what I was trying to say, just more eloquently. If you ever want to post on WPF, please let me know.

    1. That loan does not exist because it’s too good to be true. On the other hand, if it did exist, sadly, many people would turn it down.

  8. Jason – excellent post. I’ve subscribed so I can catch the rest of the posts in this series. I kind of knew the answer would be “it depends” but you’ve presented the various and sometimes complex factors that go into the payoff debt vs. invest decision in a very digestible way.

    1. Appreciate the compliment Brian. It took me about 3 months to get the mess of thoughts in my head onto the screen in a digestible way. Thank you for your subscription. I’ll make sure future content does not disappoint.

    1. You’re absolutely right that it’s not black and white. Which is why I get so frustrated when some of the famous “guru’s” imply that it is.

  9. The reason I like recommending ditching debt is I see it hold to many people back. I understand finance and have studied it now for 8 years straight which is hard to believe. The reoccurring theme I see is that those who are really wealthy never did it by keeping student loans forever or whatever form the debt may be.

    Most do it by earning A LOT and in order to do that you have to have flexibility. To many people stay in a bad job not earning enough because the debt holds them back.

    I just don’t think it is as simple as math.

    Great write up.

    1. This is a fantastic point DM. Growing the top line is key to accumulating wealth. Having no debt can give the confidence to take risks to grow an income.

      I still say that you should start with the math and then adjust for these qualitative factors from there.

  10. Great post on all the factors to consider.
    I went with the debt paydown, paying off my mortgage when I was earning top money. I don’t regret it one bit. I paid off about $100,000 while simultaneously saving $50,000.
    What I would recommend, if asked now, would be to split the money between debt pay-down, investing, and saving, one-third each.

    1. Thanks for sharing Dora.

      Why would you split the money when one choice is theoretically optimal for you based on your life situation?

      How do you differentiate between investing and savings? I tend to think of them as the same thing.

  11. Jason, you’ve captured the trade-offs amazingly well here. Great post!

    While I can definitely understand the sentiment of having zero debt (emotion), I personally decided to use math that I learned at my six-figure MBA program to draw the line in the sand. I find that having a number takes away a lot of the ambiguity around this decision.

    1. Glad you liked the post Moose. I love the logic you used to calculate at what interest rate you would choose to invest over paying off debt.

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