The Constant Tug: Should I Invest Or Should I Pay Off Debt?

The one personal finance issue that I debate internally over quite a bit is whether one should pay off debt or invest if all they have are relatively low interest rate debts (7.5% or less, for instance). All of my remaining debts are below 7% and, thanks to careful frugal living, my spending is quite a bit below my earnings each month.

My current plan is that I take that excess and split it 50/50. Half of the excess goes towards debt repayment (I’m making extra payments on my highest-interest loan right now) and the other half goes towards investing in building a small portfolio of Vanguard index funds (which I’ll talk about someday, but isn’t particularly relevant right now).

At my innermost core, I believe I should be investing all of the excess. Here’s why:

The return is better. The portfolio I’ve designed has a 13% annual return since 2000. Yes, that includes the dot com bust. That’s far better than the 7% or so return I would get from paying off debts.

It moves us more directly towards our dreams. We have long dreamed of a very nice house in the country, with a large vegetable garden, a small barn, lots of trees, and hopefully no neighbors in sight. Our portfolio is designed to make this dream come true and thus investing now pulls that dream a little bit closer.

We have a big emergency fund. If everything fell apart, we have a cash emergency fund. If we blew through that, we could start pillaging the investments. In other words, having investments keeps us much farther away from the edge of the cliff.

My wife, on the other hand, believes that we should be paying off all of our debts first. Here’s why:

It reduces our monthly expenses much quicker. By getting rid of our debts as fast as possible, we reduce our required monthly expenses much more quickly than with a pure investing plan.

It provides a tangible goal that keeps us motivated. We know the exact dollar amount of our debt and can use that as a constant motivator. It’s much easier to pull money from a more nebulous investing goal.

Freedom from debt means we never have to go back. The idea of being completely free of debt has a lot of psychological appeal to both of us – not owing anyone a dime sounds quite good.

Which is right? One could argue this subject until the cows come home without resolving it. Both aspects have valid positives and valid negatives. My belief is that if you assume personal stability over the next several years, the investing solution is better – however, if a major life change happens soon, you’ll be much happier without the debt.

So what’s the answer? Spend less than you earn, then do what seems right for you. You’re not going wrong by paying off your debts quickly, or keeping debts while investing rationally. In both cases, you’re still sticking to that central idea – just spend less than you earn.

Where do you fall in this debate?

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  1. Derek Wong says:

    I’m not sure if I’m misunderstanding, but it seems to me like that bold text at the end should read “spend less than you earn, then do what seems right for you” rather than “spend more than you earn…”. In any case, it’s always an interesting question, and I appreciate this article! It might not exactly be applicable to me right at this moment (since I have no debt to speak of), but I’m sure that knowing (or at least thinking) about it will help me someday.

  2. SJean says:

    I have 20k in student loan debt, currently with ZERO percent interst. Still, I’m barely able to withold myself from paying it off.

    Matmatically, you are right and you wife is wrong. But there is a lot more to personal finance than math…

  3. After the recent credit crunch tumble, I don’t think my heart is strong enough to survive with ease. Yes, my discretionary portfolio managed to recover and even owned one of a merger stock, but I didn’t think it did particularly well. We did have bad luck & bad timing though, bought before the tumble, and sell just last week at break even

    Meanwhile, I am determined to pay off our HELOC at price (6.25% Canada) rather than investing now. Yes, you may do 10% return on investment, but paying off 6.25% debt isn’t bad either, pre-tax. And with one less job income in the household (hopefully temporary), paying off the debt becomes more important as our cash flow is somewhat tight on the primary residence

    We have 1 rental property break-even, while just starting to advertise the rent. I am starting to feel the heat of managing rental properties.

  4. Steve says:

    I’ve been on both sides of the fence here. Currently I’m on the pay off debt side. There are many benefits to not owing anyone, especially if the economy goes South. But for me, the psychological benefit outweighs anything else.

  5. razmaspaz says:

    Well I could make the argument the whole other way. If you are consistently making 13% on your money you should really be leveraging everything you can for debt at less than 13%. If you could take out a HELOC at 7% and turn around and invest that at 13%, then it pays for itself. In fact at the end of the day it does a lot more than that.

    Fact is though, that your 13% could turn into 3% for the next 10 years. So 7% guaranteed (find a money market account that pays that) is pretty damn good. I would say pay down the debt, and then use the difference in your monthly payment to bolster your savings. In a couple years you’ll have no debt, and your savings will have grown.

  6. Gray says:

    Here’s a question to think about regarding your dilemma: If all your debts were paid off, would you borrow money at 7% interest to invest like you’re doing now with a 13% return?

    Of course not. It’s ridiculous to borrow money to invest it. There’s your answer.

  7. Madame X says:

    Spend MORE than you earn? Hope that’s a typo!

  8. Jeremy says:

    “The return is better. The portfolio I’ve designed has a 13% annual return since 2000. Yes, that includes the dot com bust. That’s far better than the 7% or so return I would get from paying off debts.”

    I think you’re being very naive here. It is very difficult to design any portfolio with an expected long-term return of 13%. You’re looking at a 7 year history which is way too short. May I ask what exactly this portfolio is? Even if you manage to come up with a portfolio with an expected return of 13% (of course I believe you that your proposed portfolio returned 13% since 2000, but I do not believe that it is possible to come up with a Vanguard portfolio of index funds with an expected return of 13%. Even if you can, it will be VERY RISKY.

    Additionally, don’t forget that you’ll have to pay taxes on those gains. The 7% on your debts is tax-free and guaranteed.

  9. shawn says:

    As razmaspaz said that 7% is a guaranteed rate of return. It’s all a matter of risk tolerance. As long as you have a solid emergency fund it’s academic for the most part, but me personally I’d rather have the certainty of being debt free.

  10. jtimberman says:

    Pay off your debt first. Your wife is right. I know exactly why she thinks that way too.

    Women have something men don’t have called a security gland. This is what lets them have a bad feeling about something. It detects risk. Its why the biggest key to the financial plan is to be out of debt with a large emergency fund piled up and NOT invested.

    See, there’s this thing that having debt brings to your home, aside from payments, and thats called risk. If you lost your income, or your means of producing income, having debt payments will cause a lot of trouble.

    Look at it another way, and this is a perspective Dave Ramsey uses with many callers to his radio show. If you didn’t have any debt, would you go borrow money to invest in the stock market? Of course not! So why wouldn’t you get rid of the debt you do have before you start investing?

    Get rid of the debt and get rid of the risk. Make your wife’s security gland relax in the process and enjoy the benefits of a happier marriage. It’s definitely working for mine :-).

  11. George says:

    If your emergency fund is fully funded, the retirement contributions are fully funded, and you still have extra, then yes, it should be invested if you have only low interest debt.

    Personally, my threshold for low interest debt is 5-5.5% rather than your 7-7.5%, but that’s because my mortgage is under 5%. I’m also using a safety margin because past returns do not guarantee future returns (see WPPS bonds, Enron, Healthsouth, mortgage bonds, etc.).

  12. plonkee says:

    In your case, the important thing is to do what will make you both happy, so the compromise is a good idea. I think that the same sort of compromise is a good idea when you can’t make a decision anyway.

  13. jtimberman says:

    razmaspaz – I would never advise anyone to borrow money to invest. NEVER. It carries too much risk, far more than the stock market has built into it (even with “safe” mutual funds).

    Dave Ramsey said this on the topic of investing vs paying off the house:

    Pay it off. Why would you keep a house mortgage? I like mutual funds, but there is this thing called risk. Take your old house payment and put it into mutual funds. You’ll experience freedom like never before. The grass in your backyard feels different when the house is paid off.

    That is investing above and beyond the 15% of income retirement savings that he recommends at “baby step 4″.

  14. will says:

    Pay it off! You don’t know what may happen when you NEED that extra cash each month.

  15. leslie says:

    Funny…my husband and I just had this conversation the other night. The only debt we have (other than our mortgage) and a fairly small car loan. I HATE having debt of any kind and we have been paying extra on it during the entire life of the loan in order to pay it off early. We are investing in several different ways right now also and so part of our money was going to investing and part to paying off the car early. Although the car loan is not huge, is at a low interest rate and is well on it’s way to being paid off quite early we decided to temporarily stop one of our investments and focus that money on the car debt. This will allow the car to be paid off early this spring (in less than half the time of the original loan period).

    Strictly by the numbers, continuing the investment was probably the right thing to do. But, I will just feel a whole lot better mentally if I don’t have that car loan any more. And, that has value too. Besides, the money from the car payment can go into the investment for a few months after the car is paid off to help make up some of the difference.

  16. Sarah says:

    “I would never advise anyone to borrow money to invest. NEVER.”

    I find this quite odd advice, for this is in fact how wealthy people and corporations operate (ever hear of “buying on margin?”). However, it’s plainly not suitable for people who can’t tolerate a significant loss in the short term, which is most people middle class on down.

    Given that you have two small children, Trent, I think it’s best to take the less risky route. What if, God forbid, anything should happen to you or your wife?

    I grapple with this issue a lot. I presently earn a lot more than I spend, but I have very large student loan debt, and I don’t want to be trapped forever in the sort of high-stress job that provides the high income right now. My private loans are at just high enough a rate that I’m not comfortable going into investments instead of pouring everything into them, even if in the long run I’d be better off doing so. A monthly nut of north of $1100 really cuts into your job options.

  17. CWG says:

    A debt is a ‘liability’.

    Going beyond the financial definition of the word, a liability is anything that is a hinderance, or puts one at a disadvantage.

    I’d pay off the debts no matter the interest rate in order to purge myself of the hinderance and not be at a disadvantage of any kind.

  18. Chef John says:

    Good treatment of an issue that I’m struggling with, too. There are two ideas not addressed here yet that make me lean toward the debt side (though not all the way!).

    1. Taxes: depending on how your debts and investments are structured, taxes could have a big impact on the relative rates of return on investing and debt reduction. Investment returns may or may not be taxable (depending on the type of account they’re in), but the money you “earn” (interest expense reduction) from paying down debt is always tax-free. Sure, we could split hairs on tax-deductible interest on mortgages, student loans, or business capital, but for the most part I think readers of this column are more interested/worried about/suffering from consumer debt (credit cards, car payments) that have no tax deductions.

    2. Risk: If the interest on your consumer debt is fixed (or adjusts infrequently, as with some credit cards) then it probably has a more attractive risk-reward profile than most investments you could make. For example, if you’ve got an 18% fixed-rate credit card, your “return” (interest saved / amount payed down) is virtually risk free: you save that 18% no matter what. For a comparable risk-free investment, you’d have to look at something like US T-bonds, which return something just south of 5%. Compare that to the volatility you’d expect from any investment with a historical 18% average return, and the risk-reward attractiveness of paying down debt is clear.

    Certainly, there are a lot of details that could sway an individual’s calculations one way or the other. YMVV, as they say in programming. But if you have the choice between a risk-free, after-tax 18% return by paying off credit cards vs. 9%-12% expected return on a stock index fund (less if it’s in a taxable account), I think the optimal solution is pretty clear.

    Just wanted to throw in those two issues – taxes and risk – for your consideration. Regardless, thanks for raising the issue, Trent, and I too feel a bit better with some dough set aside, even if it’s “suboptimal”.

  19. David says:

    What is considered a “major life change”??

    I have a 6.25% debt, but when you consider the tax write offs it is really only about 4.5%

  20. Marcus Murphy says:

    I am from the camp of invest to pay off your debts. I would invest all that excess into an account that when you reach a debt amount (high interest first), you pay it off in full and in one clean shot. Then… Rinse, repeat.

  21. Andrea says:

    I HATE having debts hanging over my head. There is no way I could do anything with extra money besides paying off more debt, even if mathematically it made more sense not to, especially on something that isn’t guaranteed.

  22. Rick says:

    I find it interesting. Trent says we can argue about this until the cows come home without resolving the issue…. and then everyone proceeds to start arguing about it. I haven’t seen the cows come home yet. But really, everyone’s just preaching to their own choir. Nobody, by any of your eloquent arguments, will change their mind.

    Anyway, I don’t see what the big psychological fear about debt is all about. Really, it’s just a number on a sheet of paper or an Excel sheet. Go out there and get a life!

    jtimberman says, “Would you borrow money to invest in the stock market? Of course not!” Actually, people do this all the time. It’s called buying on margin. Sure this adds risk to your portfolio, but every investment has some sort of risk. Your job as an investor is to manage that risk. I feel a good way to do this is to have an ample emergency fund. But once your e-fund is full, I don’t have any problem whatsoever investing on margin, and that includes investing rather than paying off one’s mortgage.

    But, I don’t expect to change anyone’s mind. Just realize that every investment has some sort of risk. Your job is to evaluate all the risks and do what you’re comfortable with. You don’t have to be afraid of debt. Debt is just a tool. Use it wisely, and you’ll come out way ahead.

  23. dong says:

    I think it’s a personal a decision and what you’re comfortable with. Personally I’m in the school of investing. If all my debts are under control at low interest level, my spending is significantly less than I earn, and I feel better off if I’m investing my money. Not only is the return better, but I believe the best way to learn is by doing (in baby steps). If instead i waited until I paid down my mortgage, not only would I being missing out on potential gains, but I would’ve missed on learning how best to invest. Obviously you can do a little of both – pay your debts down aggressively and invest. In the end it really is a matter of preference despite what the cold hard numbers may say.

  24. Geoff says:

    If you wouldn’t borrow money at ~2% interest or less than you are not very good at math. Period. I don’t care what Dave Ramsey says.

    Here’s the short answer why:
    Right now you can earn 5%+ in any number of COMPLETELY LIQUID online savings accounts. Take your borrowed money and put in it in the savings account. Subtract taxes, and you are still left with at least 3%+ return. The difference between your after-tax ROR and the interest rate at which you borrow is profit.

    Anticipated response: But those online savings accounts can change the rate on you!

    Sure, but if you make sure you’re in one that is 100% liquid (and no extra fees), if the rate drops below your break even point, then you pull it all out and pay off the debt.

    I would borrow a million dollars at 2% interest if someone would give it to me. For the same reason, I will not pay off my 1.9% financed car early unless savings rates drop.

  25. !wanda says:

    Do cows really not come home? I saw herds of domestic goats in China without a human chaperone heading home at dusk.

  26. Johanna says:

    Another factor to consider is whether you are planning to take on more debt in the future. For example, suppose you have a student loan at 5%, and you’re planning to buy a car in the next year or two. Better to put your spare money toward saving up for the car than toward paying down the loan, because otherwise you are trading your 5% student loan for a car loan that probably has a much higher interest rate.

    This probably isn’t applicable in Trent’s case, because he already has a car and a house, but it was applicable in the case of my friend who asked my advice on this very thing not long ago.

  27. Jim says:

    We paid off our debt. The emotional weight of that/those monthly payments being gone is well worth the opportunity lost in investments. It also makes you not need as big of an emergency fund which can be invested better. It was the right decision for us.

  28. jtimberman says:

    Sarah,

    This entire post and discussion has nothing to do with corporate or business finance. This is personal finance.

    I would never give advice to a company or business. They wouldn’t listen to me anyway. I’m not a CFO or even accountant or bookkeeper. My advice is definitely sound and “good” for personal finance.

  29. Steve says:

    One more thing to take into consideration is some debt is calculated from simple interest while most investments are compounded interest. Over time this can make a difference. It also is important where the debt is, credit debt has no tax benefit where if it’s a home credit line or second mortgage it will have tax benefits.Great topic, Thanks

  30. justin says:

    If the debt is less than about 5.5% I split it. If the debt is 0% it gets banked until the entire amount is due when the 0% ends. If it’s more than 5.5% it gets sped up.

  31. Baba Ghanoush says:

    Paying off the debt early doesn’t provide any extra security until the debt is 100% paid off. If you pay off an extra 3 years worth of your mortgage principal, then lose your job, you still owe a full payment next month. If that money is invested in stock funds, it may be a bit down because it’s a poor time to sell, but you still have the freedom to sell at a loss to cover your mortgage while you get back on your feet. And at the point where you have enough invested to pay off the mortgage, you can choose to do so anytime.

  32. Geoff says:

    Baba Ghanoush brings up an excellent point. It’s all about liquidity. If you insist on paying off debt early, make the payments to yourself in some sort of interest bearing investment, and then when you have accumulated the full payoff amount, get rid of it in one fell swoop. Marcus Murphy referred to this method above.

  33. Matt says:

    So you’re back in the market, Trent? You had said you took most of your money out of the market and were going to wait on the sidelines, but now you’re in. I would love to read a detailed article about your moves in and out of the market.

  34. Peter says:

    As others have pointed out, you’re assuming that the 13% you’ve had in your portfolio will be the same going forward. That’s a big assumption.

    Recent performance probably has you thinking that there’s less risk in equities than there really is. If they are indeed less risky, then expected future returns will be lower. Remember that risk and reward are related. If there’s less risk in the asset, there’s less reward. The reason stocks have had the highest long-term return is because they are the riskiest asset class.

    You’re also looking at investing from an ex-post (after-the-fact) perspective. Would you feel the same about investing instead of paying off debt if, say, the market had returned only 5% or -5% since 2000?

    Your wife is right. Pay off the debt. It’s a guaranteed 7.5% return. There’s a reason why women have historically been better investors than men – they’re more perceptive and less dismissive of risk.

  35. Arthur says:

    I am disgusted at how abusive loans can be to the uneducated. For this reason alone, I would rather not have them making money off of my money. Therefore, pay off the debt, then fully invest.

  36. Sarah says:

    Actually, jtimberman, your advice would be unsuitable for many upper-middle-class people (and on up), not just corporations, as my original post, in fact, stated. While the concept of “leverage” is often thrown around quite mindlessly by the all-real-estate-all-the-time camp, properly understood, some form of leverage is essential to really significant wealth-building.

    Now, leverage increases risk as well as reward, so I don’t think someone in Trent’s position, for instance, should be running out to open a margin account. But anyone who says a person should “never” borrow money to invest really does not understand finance. Setting aside the ability to tolerate losses, any time you can borrow money at a lower rate than you can lend it out at (including transaction costs), you should. How do you think banks have always made money?

  37. Meg says:

    In general I do the same as you. Pay down debt and simultaneously invest. If I was strapped for cash every month, though, I’d want those payments gone and I’d focus on debt repayment, assuming I could wipe it out in a year or so. If the debt is there to stay for a matter of years no matter what, then focus on investing. You can’t afford to lose that much time of compunding interest.

    Pro debt repayment:
    Hindsight is 20/20 in the investing world. If the market had been flat for the past 5 years you would wish you’d been paying off your debts. And the fact that your return has been above average in the last 10 years probably indicates that you’d be better off NOW paying down debt rather than investing–i.e. those returns will are not likely to continue to be above historical averages.

    Pro Investing:
    On the other hand, a person’s debt level doesn’t matter that much if a) it’s at decent interest rates, b) you can afford the payments, and c) the interest/payments are fixed. That’s why millionaires/billionaires don’t care about having ZERO debt no matter what: they can easily afford the payments and would rather do other things with their cash.

  38. Margaret says:

    !wanda — the cows MIGHT come home — if the gates have all been left open, and the only source of water is at home, and if nothing has scared them and scattered them off — generally, though, you will have to go and get them, but a herd that has followed the same route and has easy going cows will often follow one person (probably with a bale of hay in the back of the truck) calling “come boss, come boss, come boss”. Some cows are just devils, though, and you can have two dozen people helping chase them home and they still break through the fence into someone else’s field and hide in the woods. My dad had some of those (course they were yearlings, and didn’t have the old mature cows to follow).

  39. Michael says:

    Nothing any of us say will change each others’ minds.

    That said, I’d love to see how Sarah felt about this issue if she lost her high stress job and was left paying the monthly payment on her self-described “very large student loan debt” without a shred of income. Banks, as evidenced currently, are propped up by a system of government benefits and bailouts. Last time I checked, no one’s going to bail you out of your student loan. Unless you consider bankruptcy a viable personal finance emergency fund, in which case its clear who really does not understand finance.

  40. dong says:

    Baba Ganoush’s made an excellent point, and one very applicable to the case of Sarah. If Sarah can’t pay off the complete the debt, it doesn’t make a shred of difference if she’s putting money toward her debt or investint it and she lost her job and couldn’t make monthly payments. She still owes X amount every month. And Geoff makes an another excellent point by not paying the money into debt, Sarah would actually buy hersel flexibility and time. By not paying down her debt she would accumulate assets that she could sell off if she lost her job and couldn’t make her debt payment.

  41. Sean says:

    I think there are some things that we can say that will change other people’s minds. One of them is to point out more of the math involved, and it’s a point that people are neglecting.

    Nobody has acknowledged that the amount invested changes as a function of the required debt payment. This changes the situation quite a lot. If you invest a constant amount of money at a given rate (say 10% or so) while owing at a lesser rate (say 6% or so), you would come out ahead, obviously, compared to just paying more on the principal. What nobody has mentioned, however, is that what we’re talking about here is a debt that could likely be paid off in a matter of months or a few years. In that case, the situation you have is basically this: you could invest at an effective 4% for the course of the loan (at minimum payments, many years), or you can pay extra principal for a while, but then earn at the full 10% for the remaining years.

    It’s not a unique answer, because it depends on how much you owe and how much extra you have to pay. If you only have a little extra (on the order of the actual minimum payment, which is usually the case), you would actually come out ahead by paying your debt first. Things don’t just scale according to interest rate in this case, unfortunately, the calculation is a little harder because you eventually pay off your debt.

  42. Matt says:

    I’m one who might have his mind changed.

    I have $23,000 of student loan debt at 8.75%. I had been putting 20% of my income towards the debt and 12.5% of my income towards savings and investments. I have 3 months worth of expenses in my emergency fund. At this rate I would be debt free in 3 years but at that time I would still not have that much in the way of assets.

    Some of the comments above have made me think more about my strategy. If I pay the minimum (or a lower percentage of my income) towards my debt, sure I might have a few thousand more to pay in interest but it could mean that I have enough assets to last me 12 months or more. This would give me much more freedom which I believe is worth the tradeoff of a few thousand dollars spread out over a few years.

    I’m going to run the numbers tonight to re-consider my options.

  43. Sarah says:

    Well, Michael, inasmuch as you can’t discharge student loans in bankruptcy, bankruptcy wouldn’t be an option for dealing with them. That’s not finance–that’s law. (And I didn’t say I didn’t have an emergency fund; I do.) Snark goes better when it’s informed.

    I’ll break it down simply:

    (1) If I lost my job and couldn’t find another one, period–a highly unlikely outcome–I’d be in trouble regardless of whether I was saving or not. $1150/mo. goes through any fund pretty fast.

    (2) If I lost my job and couldn’t find one for a year, I’d be fine. I have an emergency fund and I have deferment options on my loans that would get me that far. In the meantime, since the stock market is so volatile, over the short time period we are discussing, I could not rely on not having suffered significant losses in my account just when I needed the money. Stocks are no good as short-term insurance against anything; meanwhile, less volatile investments won’t get you where you need to go vis-a-vis inflation in the long run.

    (3) By choosing to put my money into debt repayment, I can be rid of about half of my debt in about 2 years and all of it in about 4 years. Given my job within my profession, I consider it quite unlikely that I will lose my job even within 4 years, much less 2. Even putting aside my personal desire to have the option to downshift when I want to, I obviously run a greater risk of losing my job in the remainder of the 20 years that is one loan term, much less the 30 that is the other.

    My profession is rather oddly structured in that you can earn a lot of money even as a relatively new entrant in a certain narrow tranche of the market, but salaries fall off STEEPLY once you venture beyond that tranche. This is the high-risk period of my career, when I have a lot of debt to service and can only meet those payments in a handful of very demanding jobs. I’d prefer to get out of that period as quickly as possible and have the freedom to make other choices, rather than spend 20 years having to stay in that kind of job. I consider that not only more emotionally difficult, but more risky. (Fortunately, I don’t have to choose between accelerated debt repayment and funding my 401(k).)

  44. Mrs. Micah says:

    If my debt weren’t so big, it might be different. As it is, I think investing and getting in on compound interest is the best move for us. As well as paying off the debt as quickly as possible. I don’t know if we do quite 50/50, but we try to do both anyway.

  45. RichSlick says:

    This question has already been answered by the grand master himself. When Ben Bernake lowered the Fed rate, he effectively proclaimed, “debt shall be inflated away!”

    When Fed rates are low or moving lower, borrow as much as you can and invest it; that’s why the stock market jumped when the Fed cut the rate.

    When the Fed is tightening or raising rates, you should sell off (e.g. pay back) your debt.

    So the answer is:

    Invest when borrowing rates are low
    and
    Pay off debt when borrowing rates are high.

    Simple.

    It’s all very simple.

  46. lorax says:

    A fixed-rate debt is a hedge against inflation. If inflation goes up like crazy, you’re paying the debt in cheaper dollars!

    Still, I’d sooner pay down my home mortgage and then invest in TIPS as an inflation hedge.

  47. lorax says:

    My profession is rather oddly structured in that you can earn a lot of money even as a relatively new entrant in a certain narrow tranche of the market, but salaries fall off STEEPLY once you venture beyond that tranche.

    You’ve got my curiosity, what sort of job is this? It seems like the sort of thing that is tailor made for outsourcing, or insourcing if physical presence is required.

  48. Mariette says:

    I’d pay off the debt first myself – and am doing that. All this talk of margin and high-risk investing a la corporations is all fine and well, if you’re a corporation and protected from personal liability for any loss by corporate tax structures. In the personal investing scenario you aren’t protected (unless you set yourself up as a corporation) and therefore the risk is much higher – if it goes badly, you could lose everything. If it goes badly for the corporation, worst case scenario is they go out of business and the partners/board members/employees get a new job, (okay maybe not everyone can find a new job but at least they aren’t personally responsible for the debt – I’m not counting Enron-like criminal scenarios here.)

  49. Reagan Boone says:

    A quick note about the tax-benefit calculation provided above:

    “I have a 6.25% debt, but when you consider the tax write offs it is really only about 4.5%”

    This does not take the standard deduction into account. For example, if you’re married and pay $20,000 in mortgage interest during the year, you only get an additional deduction of $9,300 (above the $10,700 married deduction you get even if you have $0 in mortgage interest). At the 28% federal tax bracket, your 6.25% mortgage still costs ~5.4%.

    Compare this with a risk-free money-market investment at 5.2%. You get a 1099-INT at the end of the year, pay your 28% on the interest, and end up with 3.75%.

    If you’re the least bit risk-adverse to the market (some people are more than mouthing the word recession right now), paying off the mortgage makes sense in this scenario. Because of the 28% short-term capital gains rate, paying off your mortgage is effectively a risk-free 7.5% return.

  50. Reagan Boone says:

    A note about my above comment… I left out other deductions such as property tax and charitable contributions. You should take these into account when performing a calculation.

  51. martijn says:

    You’re comparing average rates, 7% vs. 13% annual return, what you’re not counting on is the volatility. The 7% is a very consistent ‘gain’ to be had, the 13% is very volatile – will you be able to stomach, mentally, your invested capital to go down by 30%, knowing full well that the chance of it continuing to go down for another 30% is a similar coin-flip?

    The value of an investment is best measured in its certainty of return. You are 100% certain that you get a return of 7% by paying off debt, yet very uncertain about getting a return of 13% over any timeframe.

    To further reinforce this point, have a look at how the dow jones index fared in the 20th century:
    http://www.stockmarkettiming.com/historical-charts.html

    In particular, pay attention to the time from 1900 to 1940 and 1960 to 1985 – these are very long timespans in which the return was meager indeed.

    Solid investing is about removing uncertainty (‘risk’) from the equation. The certainty of a 7% return on your investment is unbeatable.

    The only argument I can think of to invest is to develop a proficiency and comfort level with investing for when you are finally out of debt; it should only be done with money you can afford to loose; even if invested in index funds.

  52. speedy says:

    I do the same thing that Trent does, but for a different reason.

    Dave Ramsey says to pay off all debt first, then later invest 15% of your gross income for retirement.

    I respect Ramsey’s viewpoint, but I do not have a 401k program at work, and so I must invest all my retirement savings in an IRA. My contributions are limited to $4000 per year, and I am not permitted to make additional contributions for prior tax years. Instead of waiting and throwing a lot of money at the retirement fund at a later date, I am trying to partially fund my IRA this year and next year.

    If I make only the debt payments I am making now, with no extra windfall payments, I will be debt-free in early 2009. However, if my debt repayment period were longer, then I would likely feel differently and would throw more money at the debt.

  53. deRuiter says:

    When you pay off a debt at 7% interest, you are really SAVING 10%. In order to come up with 7% interest, say hypothetically the month’s interest on a debt is $70. You must EARN $100., pay your income taxes to state and Feds and ONLY THEN do you have the $70.00 to pay that amount of interest. If you spend all extra income on the debt, you are saving 10% pre tax income. Also if your portfolio is earning 13% YOU HAVE TO PAY STATE AND FEDERAL INCOME TAXES ON IT WHICH MEANS YOU ARE NETTING PERHAPS 9% OR 10% depending upon your tax bracket. I VOTE WITH YOUR WIFE, DESTROY THE DEBT AND THEN SAVE.

  54. Geoff says:

    Here’s a pretty interesting poll from the diehard’s investment forum (I think Trent is a reader) which asks at what interest rate you would invest instead of loan repayment?

    http://www.diehards.org/forum/viewtopic.php?t=4263&highlight=poll

    It looks like most would say around 6% is the magic number.

  55. James says:

    I just finished paying off all my credit card debt and now I don’t know whether to begin an emergency fund (it doesn’t need to be more than $10,000 because I’m 20 years old and still living at home) OR should I save up $3000 to begin my investment portfolio with Vanguard, with the ultimate goal of having 3 index funds with Vanguard ($9000). Not sure where to begin…?

  56. Jon says:

    But you have to pay tax on the $100 pre-tax income you “saved”, just like on an investment. So you’re not saving more than 7% by paying off the debt.

  57. Duane Gran says:

    You really have to listen to what I call the 2am test. If you can’t sleep because you worry about your debt or your investments it doesn’t ultimately matter which yields the superior return — you need to calm your nerves first.

    Both routes have advantages, but many people retreat to paying down debt or acquiring fixed income investments during a down or turbulent market when historically speaking they are better off buying securities. A sensible person balances investing and debt reduction until he is in a position to make debt profitable.

  58. Pay it off! That is my position.

  59. Matt says:

    I ran the numbers on my situation last night and really, it doesn’t make much sense to pay off my student loan debt fast. For simplicities sake, I have $17k at 9% interest. I currently have $6k in assets.

    In scenario 1, I put 20% of my income to paying off my student loan and 5% to savings, it will be gone in 2 years. However, my savings will only have grown to $11,500 (assuming 5% return). I will have paid $1500 in interest.

    In scenario 2, I only pay the minimum amount on my loan and invest the rest. In two years my loan debt will still be $14,500 but I will have $26,000 saved.

    That means I could still pay off my debt anytime after this point if I so choose but I have the added security of having much more in the way of assets. This means I am more secure than if I had paid off my debt fast.

    However, this is just looking at two years from now. I decided to see what would happen in the long run. So after my debt is paid off, for scenario 1 I start saving 25% of my income while scenario 2 stays the same.

    10 years from now when my debt will be paid off in scenario 2, I will have assets of $148,500 for scen. 1 and $145,000 for scen. 2. I will have paid $6600 more in interest but only have a net worth that is $3500 lower.

    Sure, $3500 is a lot to me now but over a period of 10 years this is almost pennies (less than 2.5% of my future theoretical net worth).

    For my situation, it completely makes sense to only pay the minimum amount on my debt and invest the rest. I think this is the key point. If I don’t have the self-control to invest the money then yes, it would be much better to pay off the debt. But this won’t be a problem.

    Another couple of points: 5% is pretty conservative – I almost get that from my bank account – and I get tax credits on my interest from my student loans.

  60. Sarah says:

    lorax: Fortunately for me, it’s a tightly-regulated profession which is very protectionist. It’s literally illegal to outsource the work I do (and also it requires sufficient adeptness in U.S. culture that it wouldn’t necessarily export well).

    I think, in the end, most people have it right: personal peace of mind has its own value. If you’re exposed to risk that makes you seriously uncomfortable, that’s a cost in itself. And–as long as you’re aware of the other costs–that can and should be factored in. Note that even though I have strongly disagreed with the idea that you should never borrow to invest, I also said I agreed with Trent’s plan to at least partially accelerate his debt repayment (and I myself am doing the same). I will feel so much better when I don’t feel that I can only work in one very narrow (and demanding) segment of my profession. The freedom to–when the time is right–take a job that pays less, but offers different personal satisfactions, is one of my biggest goals, and I’m willing to give up a few percentage points towards that goal.

  61. lockheed says:

    Matt, your math is off.

    It looks like you have about $1000 to put towards debt and/or savings each month, and $6000 in your savings account. Give or take. In any case, let’s use that amount for this exercise.

    In scenario 1, say you put a minimum payment of $215/mo on the debt while depositing the remaining $785 into your savings account gaining interest at 5% (remember, the $6K is already in there). In 10 years, you’ll have ($130,491.11 saved – $25,841.86 spent on the loan) = $104,649.25. Not bad…. but…..

    In scenario 2, you put a payment of $775/mo on the debt for two years, and save the remaining $225, upping that to the entire $1000 after the debt is paid off. In 10 years, you’ll have ($134,216.03 saved – $18,639.37 spent on the loan) = $115,576.66.

    You’re way better off paying off the debt as fast as you can. Even if you take the total paid to the loan out of the equation, you’re still ahead.

    Plus, you jettisoned the risk of the loan after the two years; you’ll be breathing easy for eight.

  62. lockheed says:

    Like everything else in life, it depends on the situation. But I would advise folks to not look at the interest rate, but rather the amount of money going towards interest. It’s one thing to say that I “only” have a 5.5% interest on my student loan debt. It’s quite another to say that I pay $250 each month into the vacuum of interest because my student loan *balance* is $50,000 at 5.5%.

    In that case if you’re not investing significantly more than $250 a month, I view that as a waste.

    I had been investing while slowly paying off my debt. Then I looked at the numbers, it just didn’t add up. I was hemorrhaging money towards interest, way more than I was even putting into my 401K. I decided to look at my financials as one entity, not compartmentalizing debt over here, and assets over there. Once I did that, I saw how dismal my net worth was and how scary my budget was going to be for the next 15 years. I cashed everything out, stopped investing, killed all the debt in a few months, and I’m investing at a greater rate NOW than I would have been able to achieve in the next 15 YEARS if I was still paying off my (relatively low interest) debt.

    My net worth is already moving upward rather than “3 steps forward, 2 steps back”. I’m even able to save up for a down payment while continuing to invest and put money towards retirement.

    Again, situations determine the rules. But in my case (single, no house), paying off the debt quickly was the best financial decision I could have possibly made.

    Besides, Trent, with all due respect, you recently wrote a couple of posts indicating a pattern of pulling out of the market when it goes down and waiting until it starts going back up to get back in. With that in mind, I really don’t think you’ll be hitting that 13% annual benchmark. You’d be best to get the guaranteed return on paying off your debts.

  63. Personally, I’d rather pay off the debt. I hate, absolutely abhor, the idea of owing a company money. I have a couple of credit cards that I’m wittling down and when the day comes when they’re RIP, I shall rejoice.

  64. icup says:

    HSBC just dropped its APY to 4.50% :(

  65. Matt says:

    Thanks for your reply lockheed. I’ll re-check things tonight. Your figures are pretty close to my actuals that I left out. The minimum payment on my loan is $226 per month and 25% of my gross salary is $890 a month. I’m paying a little under $120 in interest a month.

    Also, I get paid bi-weekly so two months of the year I get three paycheques. I took that into account for my calculations but don’t know if you would have. That could be where the difference comes from as I’ll invest much more in those months.

  66. Matt says:

    Oh, another variable that you wouldn’t know about. I’m in a unionized environment where the raises have been negotiated for the next three years. I included the raise in my calculations as well (it’s somewhere in between 2-3%).

  67. Mariette says:

    I like Duane’s reference above to the 2am test. If it keeps you up at night it’s not the right decision, your subconscious is trying to tell you something!

  68. Erin says:

    I’m in the same camp as your wife. Pay off all the debt. Just get it out of the way and then you’ll be able to throw the money you were putting on debt payments into investments.

  69. Frank Kelly says:

    I think your 50/50 approach is the right balance for you and your wife. For me an my wife we pay “minimum payments” on our savings

    1) 401k up to the match
    2) Minimum monthly contributions to
    – Two Roth IRAs
    – Two Coverdells and one 529 for our kids

    Beyond that we boost our emergency fund to 6 months. Our retiremet fund is already on track. So if there’s money left over after all that we use about 80% of it off against our high interest debt (a HELOC) and then the rest against one Roth or Coverdell fund.

    In this way we maximize the guaranteed return but don’t completely miss out on the possible opportunity in the market right now.

    Probably if the market tanks we’ll shift more to 50/50 to buy more equities esp. if our HELOC rate continues to drop.

    -Frank

  70. Matt says:

    I re-checked my calculations and found no errors. I am switching my strategy from paying off my debt early to putting as much as I can into investments. Not paying off my debt early actually gives me MORE freedom and security.

  71. Usually more cautious people tend to go for the pay off option and there is nothing wrong with this. I prefer the investment option as often your money will attract more money and it snowballs. The only thing I try and consider before I make an investment decision, is can i afford to lose this money. If not then pay of your debts, if you can afford to lose it then I would personally try the investment route with low or medium risk investments.

  72. Meagan says:

    If debt is pay off then the extra money that you would be paying each month to pay off debt could be saved at a faster pace and then take a portion of that lump sum to invest in after a period of time like maybe for a year and then you wouldn’t borrow money to invest. I don’t know how that became an option anyway…. That way if unbeknownst to you some way down the road your’re dealing with another Magnoff you will at least have less worries. In other words never put all your eggs in one basket and I’m not talking about several investment baskets… Nothing’s wrong with an old fashion savings account know return is higher than putting a sufficient amount of extra money in an account each pay period or month think about it….

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