In Which I Answer The Most Frequently Asked Question: Pay Off Debts Or Invest?

Answering the questionOver and over and over again, readers ask me some variation on this question:

I have $1,000 in my hand. I am trying to decide if I’m better off paying off part of my credit card debt or investing it. What should I do?

The thing is, my answer is almost always the same, and I thought that because it’s asked so often by email, it might be worthwhile to spell it all out in detail here because if a lot of my readers are asking, it’s probably a question that many more have, and also so that when people write to ask in the future, I can send them to this post for an answer.

First of all, this is not a question about which option is the better investment. That’s not even a question. The average credit card debt runs about 16%. The average investment earns about 8%. Treating it as cash earns nothing. Thus, the three options are pretty well graduated: paying off the credit card will net you the most “return” on your money, simply because the negative growth (for you) of your credit card balance will far exceed the positive growth of most investments.

So why even look at this question in more detail at all? The problem is that most people look at investments based solely on the expected rate of return – and that’s a mistake. With these figures, there’s a major additional risk factor that hasn’t even been mentioned to this point, one that could potentially make the investment option seem better than the credit card payoff. What is it? The person in debt is the risk factor.

In the past, I discussed how human nature is a massive investment risk, and this is perhaps the most clear cut example of what I’m talking about. Our friend here has an outstanding credit card balance in the thousands. This means at some point in the recent past, our friend has spent significantly more money than he/she has available. This is an investment risk.

Let’s say you have two people, one of whom has no credit card balance and one of whom has a $5,000 credit card balance. You can give one of them a $100 bill, but you must give it to the one who will spend it more responsibly. Who would you give it to? To me, the answer is clear: the person with no credit card balance is much more likely to be a responsible spender.

So, let’s roll this back into the original question. There is a significant risk that if the person uses the money to pay down the card, he/she will charge the card up again. This basically makes the credit card payment no different than cash in hand – either way, the money is spent on material goods. Thus, putting the money into an investment that’s difficult to touch, like a Roth IRA, may be a better choice.

What’s the best solution? Cut up the credit card and delete the number from any online accounts, then use the cash to pay down the balance. You’re eliminating (or at least strongly reducing) the human risk from the best investment option available to you, and thus in the long run you’ll reap the rewards by having significantly lower interest payments.

This overall philosophy is true no matter what the debt, unless the debt is a very low interest one. If that is the case, the investment might be the best option of all no matter what.

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  1. Kevin Zemanek says:

    Interesting perspective. Clearly human nature (or more specifically – the nature of a given individual) can be an accurate predictor of future behavior based on past behavior and can be very difficult for the individual to overcome. Unfortunately sometimes only a crisis situation (bankruptcy, foreclosure, bill collection agency interactions) will force required behavioral changes. So assuming that past behavior will continue, I like the option provided to put the money to work in a place where it is less accessible and then make it harder to make the problem worse by freezing the credit cards, cutting them up, etc.. Since some have their main credit card number memorized, you could get a new card, transfer the balance, cancel the old card – and then freeze the new card.

    Moving from credit cards to the more general topic of invest vs. paying off debt (debt in this context specifically being auto and mortgage), my wife and I had this discussion recently. Her view is one of “I want no debt. Any extra money should go there first.” I support this in principle (I also want no debt), but I take the approach of looking at cost/return based on our marginal tax rate. I also come from a family that had little savings…and have developed a strong bias towards savings. (Fortunately this didn’t require a crisis to modify behavior :-) I showed my wife the numbers (low interest car loan, low interest home loan) vs. what we could expect after taxes from a Vanguard mutual fund. Recognizing that cold logic isn’t always the best relational answer (well understood after 20+ years of marriage to my wife), we split the difference and agreed to put a portion of any extra money towards debt (car initially) and a portion into savings. Like Trent has written above, making this decision solely based on the expected rate of return would have been a mistake – at least for me.

    Thanks for a great blog!

  2. Matt says:

    I see the logic in your answer, but it seems to be limited to a pretty specific example, a person who habitually has thousands of dollars in credit card debt. I think the answer should be entirely different for people with other types of debt, or someone with only a moderate credit card balance.

    One thing you didn’t take into account is financial security. Investing may give you a better rate of return than paying off your mortgage, student loans, or auto loans. However, most of these low interest loans also come with rather large required monthly payments. If you fall on hard times, skipping your mortgage payment isn’t really much of an option.

  3. HappyRock says:

    I think that this is a great discussion, because some many people do ask this question.

    The comment about risk making the investment a better decision, is a little misleading. I don’t think TSD was trying to say that putting the money into investment is the ‘right’ decision, only that if people do not change the underlying reason of why they are spending more then the make than putting the money into debt is in essence ‘wasted’ money.

    I totally agree that people should be asking the question of why they have debt, before they go about fixing the debt. The debt will return if the income, emotional, or situation causes are not corrected.

  4. Lana says:

    Perhaps another option would be to put the $1000 in an emergency fund. As a person in her young 20s, I’ve found it MUCH easier, both mentally and financially, to pay down my credit card debts (incurred while going to school) when I know that if I miscalculate, I have a cushion to fall back on for things like food, gas to get to work, if my car breaks.

    It’s all a matter of what’s going on in someone’s own life — yes, I have debt. Yes, I accrued that debt while overspending, but I wouldn’t call all of it irresponsible. For instance, there was a period of six or so months when I was working in a job where I was promised the opportunity to make “bonuses”, but which turned out to be rather lacking, and I literally did not make enough money every month to pay my bills, get to and from work, and eat. I’ve moved up in the world now, but have debt from my experience.

    And in my case, I’d jump on an extra grand to squirrel away or put toward my debts, or, in a very likely case, split it up and do both.

  5. Rick says:

    I think it depends completely on the person and the situation. Obviously, paying off a 16% credit card gives the best rate of return. However, one of my credit cards is only 5.9%.

    I think the answer is different for each circumstance. You have to ask:
    If I pay off my charge cards, do I have the willpower to not irresponsibly charge them back up again?
    Do I have an emergency savings?
    If I invest, how liquid is the investment?
    What are any tax consequences of my decision?

    If it helps, make an Excel (or Open Office)spreadsheet and map out each scenario. What is the future value of my money if I do option A (paying off debt)? What is the future value of my money if I do option B (invest/save)? In most cases, choose the option that is worth the most.

  6. plonkee says:

    It sounds like really the answer to the readers’ question is as always “it depends”. In this case, as trent ably points out, it depends on what your track record is like with debt.

    Presumably, if, say, trent had asked someone else this question a couple of years a go then investing in a Roth IRA would have been a great answer, whereas if he asked it now (after the financial armageddon) the great answer would be on the credit card debt.

  7. Jason says:

    What about a 5% mortgage or 6% car loan? Pay off the car? Does it change things if the amount is 10′s of thousands?

  8. missiondebtfreedom says:

    Excellent post. One thing people fail to consider is risk. By reducing debt, particularly when combining that with closing/canceling any cards, you are reducing your exposure to risk. This is rarely a bad idea!

  9. Chris says:

    missiondebtfreedom: I’d say that paying the max you can on debt can be dangerous. A mortgage company doesn’t care that you paid 3 times as much as you had to last month, what they care about is that you pay the minimum this month. If you don’t have an adequate buffer to cover that. So even though for the year, you can be ahead, you can also be late and getting in trouble. Basically, don’t overpay debts to the point you can’t handle trouble, even if it doesn’t lead the the optimal math.

  10. Eric says:

    I only pay down debt in one situation.

    1) I can pay it off.

    Otherwise I’m throwing liquid assets at a non-liquid debt and I’m not even gaining the monthly payment back into the budget. it helps that I don’t have a high rate on any debt because they are either secured ( home, vehicle ) or student loans.

    All my emergency money / savings sits in a high yield account. I used to use rotating CD’s but they can’t beat the convenience of internet savings accounts they have today.

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