I recently had a reader who wanted me to write an article on whether it’s better to pay down debt or invest. Seeing as how I was recently profiled over at No Credit Needed I figured now was as good as anytime to tackle this subject.
What’s better, paying off debt or investing?
My theory is that I’d rather have less debt because I don’t like owing money even if the interest on debt is less than the return on the investment.
Well John as with most questions there really is not a right or wrong answer. It really depends on your situation and your personal feelings towards carrying debt. Growing up I was a person who had a personal hatred towards debt. I never wanted to owe anyone anything. I was going to pay down my student loans the instant I graduated, I was going to pay down my mortgage as fast as I could, and I would never in a million years carry a balance on a credit card no matter what the circumstance. Which I think is probably similar to the view you have.
My changing attitude towards debt
Shortly after graduating college I entered an MBA program and I can’t even pinpoint the class anymore, but suddenly I started seeing two kinds of debt. Good debt and Bad debt. In essence good debt was debt who’s interest rate was quite a bit lower than I could fairly easily make in the open market. Bad debt was debt where the interest rate was the same or more than I could easily make on money on my own.
So all of a sudden things like my student loans which were locked in at 2.8% and tax deductible suddenly became good debt, and I realized I would be a fool to pay them off early. I still detested credit cards with a passion, but I realized that if someone were going to give me money on the cheap I should gladly take it off their hands if all I had to do was give it to someone else who would pay me enough to cover my debt’s interest charge and leave some extra money in my pocket to boot.
It’s simple math
In theory the decision whether to pay off debt or invest is simple math (at least for me).
Rate of Debt vs. Rate of Return on investments x (1- TaxRate)
Or if you have debt that is tax deductible, such as student loans, mortgage, or HELOC you can use this formula
Rate of Debt x (1- TaxRate) vs. Rate of Return on investments x (1- TaxRate)
If the Return on investments side of the equation easily outweighs the debt side of the equation then you are better off investing money. If the debt side is bigger than you should be looking to pay off your debt.
Things to consider first
- Make sure the rate of return on your investments is a sure thing, because the debt side certainly is. Don’t blindly think that you can get a 10% return because you are going to invest your money in the stock market. You have to pay debt in the short-term so for the most part your investments should be safe short-term investments.
- You actually have to invest the money. You can’t just say ohh I can make a higher return than the debt I’m paying and then leave the money sitting uninvested (I know it’s common sense, but I’m an idiot)
- Rates of debt can be variable and so can investment returns, so what may be a invest vs payoff debt situation today may not be the same a couple months down the road.
There’s a lot more to it than just math
Ok you got me, even from a purely financial standpoint it might make sense in some situations to keep the debt and use the money elsewhere, the safe bet is probably to pay off the debt. Paying off debt gives you a sense of control over your life and can be a very rewarding experience. There have been countless stories of people concentrating on paying off their debt and that momentum keeps carrying them onto a life of wealth and riches.
Debt = stress, so paying off all your debts can free you up to do many things that you might not have been able to do before when you had debt. I have never carried a balance on my credit cards, but I can only imagine the sheer jubilation that is felt by people who crawl their way out of thousands of dollars of credit card debt and they get to a point where the credit card statements stop coming each month and they have nothing but $0 balances across the board.
I’m a homeowner now and as much as I think my mortgage is “cheap” money (locked in at 5.625%) I couldn’t argue with you that I would feel a complete sense of control and relief if I no longer had to make monthly mortgage payments. If I got laid off it wouldn’t even be that big of deal because short of a mortgage payment I think I could live off cash reserves for quite a while. Having to pay other people for using their money means that you have to keep working and if something bad ever happens well things are probably 5 times more stressful because of the debt.
The real answer
If you are a seasoned investor AND can very safely get more on your investments than your debt costs you AND you can handle the fact that someone else has some control over your life because you have their money AND you feel very confident that nothing major will likely happen to your income during the time where you are carrying debt, then by all means go ahead and keep the cheap debt (notice all the ANDs).
In other words, for the typical John on the street the answer is you probably should pay off your debt first. You can never really go wrong paying off debt. However taking on or keeping debt can end you up in a world of trouble fast if you aren’t careful or something unforeseen happens.