Should I Pay Debt Or Invest?
“Should I pay off debt or invest?”
This is a flawed question.
When you take on debt, you’re pulling your future spending to the present.
Borrowing money from a bank comes with a cost which is interest.
Because the bank wants their money back, they attach a repayment schedule to that debt so they get their money back within a specified number of years.
This means you’re already paying back the debt.
So, the better question to ask, is:
Is the accelerated repayment of my debt better than the potential future interest earned through investing?
Let’s also not forget:
When you accelerate your repayment of debt, you’re paying more towards the principal balance (the actual money you borrowed) to reduce the future interest the bank charges on that balance.
Let’s play this out.
Say you buy a car worth $30,000, the interest rate is 7% and you repay the car over a 5 year period.
Monthly payment = $594.04
Total interest cost = $5,642.16
Say you add an additional $100/mo to the repayment of this debt.
Monthly payment = $694.04
Total interest cost = $4,669.83
Total time saved from the repayment of debt = 10 months
What was the total interest saved through accelerating your repayment of debt?
$972.33
If you factor in the fact that the repayment of debt would free up $100/mo of cash flow 10 months sooner, then invest that $100/mo (assuming 7%) what would your total return be?
$1,998.99
Considering our alternative:
If you would have invested the $100/mo from the start (assuming 7%) what would the total return be (assuming a payoff time of 50 months)?
$5,786.11
Total benefit to invest versus pay off debt?
$3,787.12 (in favor of investing)
Why is this?
When you pay off debt, you guarantee yourself a fixed simple interest rate of return.
When you invest, you guarantee yourself a compounded rate of return.
Your $1 dedicated to paying off debt does not grow in total debt repaid over time.
Your $1 dedicated to investing does grow in total interest earned over time.
This is what many fail to understand.
Your $100/mo that you’re investing in month one earns $7 (7% interest).
That same $100/mo that you invested in month one, in month forty-nine earns $180.10 (2,473% interest)
This is your interest earning interest through time.
This difference is what makes investing (& compound interest) so powerful.
But there’s a wrinkle here:
To simply state that your debt is 7% and market returns 7% is not enough to justify investing over paying off debt.
Conventional math fails here.
You ignore:
Impacts of leverage, volatility, sequence of portfolio returns, future market returns, underlying debt repayment schedule, and taxes.
The market doesn’t move in a straight line, you incur volatility.
When you incur volatility, your actual return suffers as a result (through what’s known more technically as volatility decay).
If we consider the same idea above using historical monthly S&P 500 returns, what happens to our result?
You end up with $5,732.52.
In this example, the impacts of volatility and the sequence of market returns cost us $53.59.
This doesn’t seem like much but if we considered this over a period of time where the market had negative returns over 5 years, our results would be different.
When you invest over paying off debt, you trade certainty for uncertainty.
If you take on debt that allows you to become more productive and increase your earning power (think buying a lawnmower to cut grass or acquiring a new skill that allows you to charge/earn more) or hold an asset that provides income (think rental real estate), this is leverage working in your favor.
This changes the return on investment of taking on debt (some would call this good debt).
In the example discussed above we considered an auto loan, which is amortized over time.
Meaning, early on, most of your repayment is interest then over time this shifts to being mostly principal.
Banks do this as a risk management measure to ensure they can get most of their interest back as quickly as possible in the event that you default on the loan.
Additional principal payments on amortized debt don’t go that far because of how the underlying loan is structured.
On the other hand, if you have a line of credit, this type of debt allows the interest to be calculated off the outstanding loan balance, which would make additional principal payments more favorable because it has a greater impact to reduce the amount of interest that is charged.
The downside of this type of debt, is that left unchecked can compound over time (against you, not for you) that makes getting out of debt harder (think credit cards, securities backed line of credit, and home equity line of credit).
Or if you have student loans and are on an income driven repayment plan, your repayment is based on your income and offers the potential for future loan forgiveness (which is an entirely different return on investment calculation).
In some cases, interest paid is tax deductible which also impacts the return of paying off debt.
This would be the case for interest on debt used in a business, mortgage interest (if you can itemize on your tax return), and home equity line of credit interest (used for home improvements only).
Regardless of these wrinkles, it doesn’t change the biggest factor of this equation which is investing offers compounded returns and debt repayment offers simple interest returns.
Some other factors to weigh in your decision to pay off debt or invest would be:
Your attitude towards debt (or what I like to call, the sleep at night factor)
If you hate debt, this will play into the decision to pay off debt. We’re humans and also have to factor emotions into this decision.
Your debt-to-income ratio
If you’re someone who has a high debt-to-income ratio (I would consider this to be above 36%) then we would have a different conversation around cash flow. Spending less than you earn is #1 on the list of creating financial success and too much debt is an easy way to derail your financial goals.
Your tolerance for market risk
If you can’t stomach the market’s volatility, or prefer to keep your assets invested very conservatively, then this would change the conversation around which option would make the most sense for you. My first approach would be education around why stocks and bonds behave the way they do and seeing if this is something we could adjust your current belief system on.
Market valuations
While I am a firm believer of time in the market being the biggest predictor of financial success, I also understand that when markets are expensive, the prospects of high future returns are low (& vice versa). This wouldn’t derail me from continuing to invest (as we don’t know what future returns will look like) but will serve as a datapoint to consider in the overall decision.
Personal finance is many times more personal than finance (we don’t live and die by spreadsheets).
The answer is rarely to only invest or only pay off debt.
So the choice is yours:
Do you pay off debt or invest?