The most common question I receive is “Should I pay off my debt or should I start investing?” The answer is, as most my answers are, it depends. It depends on many factors such as your debt type, interest rate, risk tolerance and your attitude towards debt. Paying mortgage vs. saving for retirement is an ongoing debate I don’t see an end to it anytime soon. The most common advice is to pay off your consumer debt (credit cards and car loans) then start investing while paying down your mortgage and student loans. The rule of thumb is that the after tax return on your investment should be better than the interest rate you are paying on your debt. This is a good rule of thumb to use, but it only captures the math in the process and leaves out the emotions and psychology of the individual. Works well in some cases and not so much in other cases, I am not talking about the math component of it.
What to do?
So what should I do? My answer is do what you are comfortable with.
1. List Your Debt with Interest Rates
Grab a paper and pen and write down all your debt, everything. Now rank them with the highest interest first and so on, use effective interest rates if it is tax deductible. Also include the term length if there is one. You should have a neat list with all your debt in order from highest to lowest.
2. Budget and Emergency Fund
Before going ahead ensure you have established a budget and are not running a deficit. Also make sure you have a sufficient emergency fund (6 months worth of expenses is a good place to start). It’s important to have these two in place before you start investing, because if you are running a negative budget you will be in trouble soon and an emergency fund will protect you and your investments in case of an emergency.
3. Do Some Math
Now it’s time to do some math, yea the fun part J! Look at your effective interest rates and see if you can earn more than that AFTER taxes in your investments. Example:
You have a $15,000 balance on a credit card with a 20% annual percentage rate. Credit card interest expense is not tax deductible, which means that you should only invest IF you can get better than 20% annual return. Looking at the market history the average annualized return is about 10-12% per year.
Therefore, it does not make any sense to invest if this is the case. As a rule of thumb you should always pay off your credit card debts before investing, the interest rates on credit cards and department store cards are astronomical. Look at paying your credit card debt down as investing, you are getting a guaranteed 20% return on your money, you will never see such guaranteed return. How? By paying down the debt you are saving 20% that you would have otherwise paid in interest – which is now in your pocket.
Let’s look at a different example, where it may make sense to invest.
Assume you have a twenty year, $200,000 mortgage with a six percent rate. For simplicity sake we assume you are in the 25% tax bracket. In the US your mortgage interest can be tax deductible so in this case your effective interest rate will be about 4%, in Canada we are less lucky and our mortgage is NOT tax deductible so our effective interest rate will be about 6%.
In this case you expect to earn an after-tax return higher than 6% (or 4% if mortgage is tax deductible) on your investments then you should invest. If you have a well diversified portfolio than your chances of beating this rate are very good.
4. Emotions
So we did the math and know when to invest and when to pay down debt, but there is more to our thought process than just math. Nobody can answer this question but yourself, how do you feel about debt? Some people hate debt, others don’t mind debt so much. Which group do you belong to? Maybe you want to reduce your debt load before investing even though the math says you should invest now. What is your attitude towards debt? If you want to reduce debt than set up a debt reduction plan and work aggressively towards it, otherwise you will never be able to invest and save for retirement.
Bottom line: Look at all the angles and do your math, but do NOT forget your emotions and attitude towards debt. Do what you are most comfortable with; there is no point in investing and not being able to sleep at night.
Do you pay down your debt or invest? What was your thought process in reaching your decision? Any tips or tricks – please share.
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Article by Ray
Ray is an ex-financial adviser and the founder of Financial Highway. Currently working in the financial industry and working towards completing his Chartered Financial Analyst, CFA, designation.
Ray has written 271 articles.
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{ 8 comments… read them below or add one }
I think that’s a great analogy. And if you are thinking about your finances the same way you would run a business, then you are analyzing whether your expected returns are a significant margin above your cost of capital (your current debt load).
Ray I loved how you laid it out, so many times a simple logical approach can keep you from making stupid choices. Had I learned that earlier I’d be a rich man today
. For me we are heads down debt busting and it works well for us. We’re taking advantage of the singular focus and then on to a full fledged emergency fund and then investing for retirement.
Great way to describe the it all but I think it would make sense to pay off the debt first. Focus on one task and work on that like Paul did and then you can begin to save care free.
It’s not always an easy choice to make between paying debt (mortgage, student loan) or investing…it depends on many factors but one important factor people leave out often is their emotions…that is what I tried to point out…it’s not always just about math….as Paul points out focus is key and it is never too late
Great assessment. It’s hardly ever an either-or situation, as a lot of emotions/fears come in to play.
The option I went with (as did a number of people I’ve talked to about this) was to pay down high-interest credit cards at an aggressive rate until they got to a more manageable point, then divert some of that to investing in retirement.
While from a mathematical point, it may have made more sense to pay off ALL CC debt first, the fear of waiting too long to start investing was too large for me.
Hey Ray,
THANK YOU for writing this article. I’ve closely examined my “money psychology” and while I’m carrying some debt, I’m not comfortable with it … AT ALL.
I’ve been rather careless in the past and I want to take a disciplined approach to handling my finances till I emerge from it and only then will I want to leverage “other people’s money” to invest.
In the meantime, I’m building up a small emergency fund to cushion myself from anything that may pop up.
The emotions portion of your article really resonated with me.
Cheers,
Will
In any analysis of whether or not to pay off debt versus invest, it is critical to take into consideration the risk of not being able to pay off debt moving forward. Many are not aware that the risk increases from uncertain interest rates, so those with ARMs or credit card debt need to take extra care. Furthermore, the risk increases when cash flow evaporates, so doing a dead honest estimate of one’s job security is key. Modifying these factors is any cushion is savings, or more generally, any personal assets that can be liquidated with short or medium-term notice for “emergency debt paydown”. Admittedly, it is difficult to accurately determine whether to invest or pay down debt, so paying down debt is the safer bet — unless there is already a high chance that ongoing debt payments would be for nothing, e.g. if a home is going to foreclose no matter what.
With stocks you have to pay capital gains tax and dividend taxes on your investments which lowers your return rate.
The stock market is unpredictable. The S&P 500 went down over 37 percent in 2008, which will take many years to recover from. I think paying off your mortgage is a safe bet.
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