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Should You Pay Off Debt Before Investing?

Big payments on credit card debts, student loans and mortgages eat away at how much you can save or invest. A sense of obligation or even guilt can dissuade people from opening an investment account and funding their retirement portfolios before these debts are paid off. That could be a costly mistake.

7214463188_0ecb8b475c_zOne of the biggest decisions you’re going to face when beginning to invest is whether or not to pay off debt first.

Looming credit card debts, student loans and mortgages have large appetites that demand attention and eat away at savings accounts and investment possibilities. A sense of obligation or even guilt can dissuade people from opening an investment account and funding their retirement portfolios.

Your debt’s APR vs. your portfolio’s expected return

The key to figuring out whether it’s more useful to pay off debt or invest can be found by looking at the interest rates associated with either choice.

For example: if you have a $2,500 loan at a 6 percent APR but could invest somewhere else and get a 8 percent rate of return — it would make more sense to invest that money instead of paying off the loan.

The average investor can expect to see long-term returns in a diversified investment portfolio of around 7.5 percent. With that benchmark in mind, we can say that debt with an interest rate higher than that should be paid off, while debt with rates of less than that aren’t worth paying off — unless you’re trying to free up monthly cash flow.

Here’s another example: Mark has a car loan of $10,000 at 5 percent interest for 5 years. He will pay $12,762 over that time. If Mark invests at 7.5 percent instead, he would end up with $14,356 — a difference of $1,594.

When to pay down debt first

Credit card debt is the number one reason why people put off investing. This type of debt comes with high interest rates and a small minimum balance that needs to be paid every month, keeping you on a paycheck-to-paycheck lifestyle and unable to save.

In almost every case, paying off the credit card is a better decision than investing and accepting a lower rate of return than feeding the insatiable interest rate on the card.

Investing vs. paying down a mortgage early

While often considered “good debt”, mortgages can still be a hindrance to your investment portfolio.

In these cases, people believe that their houses count as an investment and take on a higher payment than necessary, preventing further diversification. While a house may be a viable part of one’s investments, the bursting bubble of 2008 will tell you that other assets will be needed to maintain a healthy, diverse portfolio.

Other loans such as car notes or student debt generally aren’t an obstacle to investing. As interest rates on these products are typically lower than the returns you could expect to receive on other investments, there’s no urgent need to pay these off first. These loans come with an amortization schedule, unlike revolving debt such as credit cards, which means payments are easy to anticipate and not subject to rate changes.

A note about student loans — interest rates temporarily spiked to 6.8 percent in July, necessitating a change in college planning. While a bill was passed that returns the rate to 3.9 percent, there is little doubt that rates will rise over the next year. The positive takeaway is that the interest payments on student loans are a tax write-off.

Starting an investment account is an important step in your financial future, and debt shouldn’t take center stage. There is a certain psychological benefit in knowing that you have begun to invest and even in instances where debt exists, it’s not wrong to set up a small monthly deposit account in a mutual fund to get things started.

How do you decide between paying off debt and investing?

About Daniel Cross

Daniel Cross has been in the industry as an investment writer and financial advisor since 2005. He holds the Chartered Financial Consultant designation (ChFC) as well as Series 7 and Series 66 licenses, and has embarked on the arduous journey of obtaining the coveted CFA designation. Daniel lives in Florida with his wife, daughter, and pet Tortoise ironically named Turbo.

Comments

  1. Paying off debt would come in first for me. Apart from the financial burden, debt also carries with it an emotional burden. You get worried about what you would do if you failed to pay your debt, whether your house would be foreclosed on and more importantly, you might fail to seize business opportunities when they appear because you are saddled with debt.
    At the end of the day though, I guess it depends much on the kind of debt and ones financial situation.

  2. Great article. This is such a critical discussion for anyone coming out of school and unfortunately a lot of people I have talked with don’t even consider investing as option. It’s easy to say the decision should be based on the numbers, and it should for the most part, but there is a psychological boost to getting rid of debt and freeing up that money.

    Though I also believe that even if you have higher interest debt, investing even a little bit early on can certainly help. For example putting away $100/month into a Roth IRA is a great start. As you whittle down your debts, you can add more to that over time. Ultimately this can be an emotional decision but as long as it’s increasing your net worth and youre comfortable with it, go for it.

  3. I agree with Simon that it does carry an emotional burden, but with the mortgage interest rates we’ve seen over the past couple of years, paying down a mortgage is one of the last things I would do.

  4. Jen Spradley says:

    This article is very relevant. I learned this principle in a finance class a few years back. However, this article touched on key points that were extremely relevant to Generation X. Thanks for this article and the blog, too!

  5. I agree as well. Though the potential gains in investing can be very appealing to many , it is also a double edged sword with huge potential for loses for the unexperienced and even experienced investor. I learned this first hand as a young ambitions 25 years old investor and had I known what I know now I would of simply paid down debt and freeing up more disposable income. As far as emotional burden of having debt, imagine riding on the emotional roller coaster of INVESTING watching your money jump up and down in the stock market daily.

  6. I would argue that a straight interest rate comparison doesn’t give you a full picture of your investments. When comparing stocks, investors take into account the risk associated by using beta. Risk analysis is ignored above. Also, if you keep an emergency fund of 3-6 months in cash, extra consumber debt payments increases your fund size. This extra amount is more money that won’t be making you money.

    With mortgage rates so low, I agree with you on not racing to pay it off. Otherwise, paying off consumer and school debt is almost always better than investing.

  7. Keep in mind that even when your goal is to pay off debt, if you can invest at a higher rate of return somewhere else, then that excess money can be used to pay it off quicker.

    • I agree, if you can find something extremely stable. Most stable investments have very low interest rates. Liquid assets with high returns (ie. stocks) should not be purchased unless you can go without that money for at least 5 years. If you need it sooner, you are not investing. You’re gambling. It goes back to risk tolerance.

      With the exception of your mortgage, you should not have any debt that takes you longer than 5 years to pay off. If you take longer, you are either in a serious amount of hurt (and should not be investing in anything) or you are not serious about paying the debt off.

  8. Other than a home, you should ALWAYS pay off debt first even if it is at a lower rate than you may think you can get investing. Think of it by starting from zero. If you had zero debt, would you borrow 50k at 4-6% in order to invest it? No, that would be foolish. Pay off your debt first and then you will be able to put more money towards retirment than ever before, and with a clear conscience.

    • Daniel Cross says:

      Think about this way. If you could borrow 50K at 5% interest and invested it at 7.5%, you would still end up with a profit. Now obviously the big problem is that stock returns can’t be guaranteed, but using leverage to invest is widely used in the investment community. If you open a brokerage account, you’ll have the option of cash or margin. Margin allows you to borrow money at a predetermined interest rate for the sole purpose of purchasing more stock.

  9. I’m a fan of paying debts down first… more for the emotional factor. That being said I take advantage of investment vehicles that offer tax benefits first, like 401k and Roth IRA.

    Also I was about to challenge the claim of a 7.5% annual return, post tax, for investing. But looking at some S&P charts (outside of the recent bubble busts) and they’ve been mainly near double digit returns. So I stand corrected! :-)

  10. I know this is a minor point, but student loan interest is only deductible for people who make under a certain taxable income, it gets phased out as one approaches that limit, and there is a maximum interest deduction one can claim of somewhere less than 3k. As if having student loans wasn’t bad enough, if you have large loans and live in a region where income is high, you get no deduction and it stings.

    Regarding the borrowing to invest discussion, yes the expected return of an investment portfolio should be used to determine what the best option is, but that only is true for someone who can continue to meet their minimum debt servicing requirements in the event of minor/major market declines. Aside from just losing capital, would it have an impact on one’s employment?

    I know that sounds like I would never advocate using borrowed money to invest, but there are situations where it makes sense, and it is pretty subjective. If you have an 80k set of student loans at 6% and could invest at 7.5%, that is really only attractive if you have significant liquidity available to cover your debt in the not uncommon case where the investment only returns 2%, or worse yet, less than 0%. And if we are talking about diversification, you cannot diversify away systemic market risk, and would need lots of capital(or would be impossible) for that to be the only risk in your portfolio.

    • Daniel Cross says:

      You are correct. Some common sense should be applied when making the decision to invest or pay debt first. Realistically, most people will attempt to tackle many problems at once: save for an emergency account, pay down debt, invest in a 401K, etc.

  11. I’m all for paying off debt, but if you have no emergency fund and credit card debt, it makes sense to allocate some towards both so that if you get in a pickle with income or other expenses, you can at least maintain your minimum debt payments.

  12. I always do both – pay down debt, and invest.

    If you’re young and you’ve never been debt free, I highly recommend paying off all your debts so you can experience the feeling of being free. And enjoy it, because it’s only going to last until you buy your first house…

    For most of us, we’re in debt our entire lives, so the best thing to do is to pay it off as well as you can, but never let it stop you from investing in a financially free future.