Updated on 07.31.08

Looking at Debt Repayment as an Investment

Trent Hamm

DEBT FREE AT AGE 28!! by lemonjenny on Flickr!Quite often on The Simple Dollar, I’ll mention the advantages of getting your debt paid down. For most debts, paying them down is the best thing you can do with your money, provided that you have a small emergency fund set up to protect yourself against the unforeseen and at least some retirement savings.

As soon as I mention this, however, a number of commenters will show up and claim that debt is great as a leverage tool, that it’s free money if you can reinvest it and earn more than the interest rate.

Here’s the way I look at it: if you’ve already incurred the debt, an extra debt repayment is an investment an after-tax and almost risk-free return equal to the interest rate on your debt.

Here’s an example. Let’s say I have a home mortgage at 6%. If I make an extra mortgage payment on that debt, every extra dollar I invest will return 6% after taxes to me over the life of the loan. Similarly, an extra payment on a 13.9% credit card debt will return 13.9% after taxes to me over the life of the loan.

This is not to suggest that debt itself is a good thing. You’re far better off saving up money for big purchases in advance than you are taking out debt to buy the items. For example, if you know you’re going to buy a $10,000 car in two years, your best move is to start putting $400 a month into a savings account right now, which will add up to nearly the cash value of the car. Otherwise, you’ll be saddled with a $10,000 loan, which will equate to approximately $250 a month payments for four years – far more money spent than if you’d saved in advance.

Let’s look at comparable investments. The only investment available to most people where you can put in after-tax money and not have to pay taxes on the return is a Roth IRA, but it has the restriction that you can’t take your earnings out until you’re 59 1/2. Also, some municipal bonds earn tax-free income, but they generally have low rates of return – 3% or so.

Almost every other investment vehicle requires you to pay capital gains tax. Money in a savings account? You’ll be paying short term capital gains taxes on that – basically, your normal income tax rate. Money in an investment? You’ll pay short term capital gains on any dividends you get and also on any investments that you sell within a year – you’ll pay long term capital gains tax on ones you sell after owning them for more than one year (that’s 15% for most people).

Even worse, returns on most investments aren’t guaranteed. Almost every investment option that earns over 5% does not have a guaranteed return – they’re usually based on the fluctuations of the bond market, the stock market, the real estate market, or so on. Because of that, by owning the investment, you’re taking on risk that you wouldn’t have by repaying your debt.

Let’s look at an example. Let’s say I have a debt on a big furniture purchase that’s sitting there at 7%. Every extra payment you make on that debt is the equivalent of a 7% investment with no risk.

If you’re in the 28% tax bracket, in order to beat the debt repayment in a savings account, you’d have to find one earning 9.72%. Even an investment earning only long-term capital gains tax, you’d have to find a riskless investment that earned you 8.24% annually – not going to happen.

You shouldn’t pay down your mortgage or your student loans because of the tax benefits! Yes, some debts have tax benefits and those should be looked at carefully – but not overinflated. On student loans, you can deduct the paid interest each year, but all extra payments will do is reduce the amount of interest you pay in future years, just slightly reducing your deduction there. On home loans, most people look at the deductible amount of their interest, but they neglect to look at the fact that they can deduct a good chunk of that anyway via the standard deduction – their actual extra deduction due to their house is often much smaller than they might think.

It is never a mistake to pay down debt. Sure, one can formulate situations where you might earn a bit more by doing credit card balance transfers or only paying the minimum on a very low interest debt, but those situations are few and far between, have other risks (such as unexpected changes to terms and conditions and a mis-step in managing the accounts) and don’t earn you a whole lot.

In my view, debt repayment should come fourth on your financial to-do list. First, spend less than you earn every month and master it – stop building more debt right now. Second, get yourself an emergency fund – preferably a couple months’ worth of living expenses for each dependent – and keep it in a very liquid place so you can get it when you need it. Third, save for retirement. Fourth, get rid of your debts – at least those over 5% or so.

Follow that game plan with all the passion you can muster. If you can check off all four of these, then it’s time to start looking at investing and other options. That’s how I’m rolling – I’m deep into step four and already looking ahead at a bright future without debt.

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  1. MJ says:

    All of the tax consequences you laid out are on the mark.

    This is why rental real estate is probably the best investment for the average person. As long as you buy and hold, the tax benefits are awesome. Up to a point of, course. But massive tax-free wealth can be built.

  2. RWyler says:

    “Third, save for retirement. Fourth, get rid of your debts – at least those over 5% or so.”

    Doesn’t this statement contradict the rest of the article? I’m all kinds of confused about what to do with my little bit of extra money each month. Should I be saving for retirement (an investment), or should I be paying down debt (mortgages@6.3% & 9%, car payment@7.25%, 2 student loans@3-4%)?

    My employer matches 4% on my 401K, so I contribute exactly that amount since it’s an instant 100% return on investment, and then I put any extra money after bills each month into an ING direct savings account. It started out small, but there’s a decent amount of cash in there now, more than enough for an emergency fund, and I’m trying to decide what to do next. I was going to open a Roth IRA with it, but I’d rather have it more easily accessible if I need it before I’m 60 (I’m 25 now), so I thought that I could just pay it toward the mortgage and tap into it with a home equity loan if I absolutely had to. But I could just pay the car off and eliminate that payment entirely and snowball that amount into putting more toward a mortgage. I’m just not sure what would be a good course of action for me. Any ideas?

  3. troy says:

    Nice post.

    Here is a simple example for always paying debt first instead of investing.

    All debt consumers have is money lent based on risk. These are usually large, complex corporations, and they have deemed that lending money to “you” at the specified rate is the best investment they can make with that amount of capital and risk. Little old you can match that rate….WITH ZERO RISK, by simply paying it back.

    It is very simple. If there were consistently better returns available with less risk, these companies would have invested THEIR money there instead,not in you.

    FYI Trent, People do not “have” home mortgages or “get” mortgages. They GIVE them. People have home loans, not mortgages. The lender has the mortgage in exchange for money lent.

    Rock on!

  4. George says:

    Trent, I totally agree.

    If you have the money you should always pay off your debts like credit cards and according to Suze Orman even your home mortgage despite the interest deduction you get.

    There are a bunch of crazy so called “financial experts” who advise otherwise but they are often not in a good financial situation themselves.

    Its kind of like going to join 24 Hour fitness and getting some overweight personal trainer who supposed knows a lot about fitness but they don’t really practice it themselves.

  5. Laura says:

    I agree Trent on the wisdom of paying down debt. I am working on eliminating a high interest car loan (13.75%) that I gotten while I was at school. It’s down to around $1800 right now and I hope to pay it off by December.

    Once I’m done paying this off, I’ll have an extra $235 a month to save. It’;; be like getting a raise.

  6. MegB says:

    Unfortunately, not everyone gets a tax break on the student loan interest. Being able to deduct the interest is entirely dependent upon your adjusted gross income. Ours is (fortunately or unfortunately) too high to qualify. However, the interest rate is extremely low (2.7%), so we are continuing to pay the minimum while building up our investment portfolio right now because we fell a little bit behind since I was in school. I’m sure we’ll pay more than the minimum in a year or two and work really hard to eliminate that last bit of debt. Yea!

  7. GM says:

    To MegB and Trent,

    I have about 20k in student loans. Half are federal around 3.6% and the other half are private around 5%. I will be making roughly 60k in gross income. What is my best route? With my income, will I be able to get a deduction on the interest paid or not? I’m trying to decide whether to try to pay this debt off ASAP instead of maxing out contributions to Roth and 401k. I’m still planning on contributing both, just not as much in order to pay off the loans quickly. It would be so nice to just get rid of the debt.

    Any suggestions?

    Thx, GM

  8. I like your advice, Trent, and often give similar direction to my clients (recall, I’m a fee-only financial planner).

    Be mindful though of the loss of financial flexibility that can come from overzealous debt repayment. I’ve encountered more than a few families that eventually regretted paying off low-rate, tax-deductible HELOC’s and mortgages.

    In some cases, they assumed the HELOC could be tapped if they needed quick access to money for home repairs, college tuition, income smoothing, investment opportunities, etc. This is NOT a safe assumption since the small print of every HELOC I’ve seen allows them to cut you off if/when they please … without restriction or appeal. They will bounce your check and leave you “high and dry”.

    Other people assumed they could refinance a mortgage if they ever needed to tap the home equity they’d built up. As home prices softened, their equity disappeared, as did their plan of tapping the money for unexpected situations (be they good or bad). If the home can’t even be sold, the “home rich, cash poor” dilemma is even more obvious.

    If you’re curious, check out my podcast on this topic: http://www.money-guy.com/protecting-yourself-u-s-banking-system-under-stress

    In both cases, these families wished they’d remained more “cash liquid” even if had meant carrying the debt a little longer. Since the debts were often @ 4-6% (pre tax), I think a case can be made that reasonably safe investments could have been found with returns that would have paralleled the gains from paying off these loans.

    That said, I completely agree with you that high rate, non-tax deductible consumer loans should always be paid off quickly (or never incurred in the first place). A 15% credit card rate should have a bulls-eye on it :-)

    And my advice is only that: something for people to consider based on their needs and situation. No plan ever works for everyone! As with everything, do your homework and consult a trusted adviser.

    Brian Preston, CPA, CFP®, PFS

  9. clint says:

    I would say always pay down the debt that you can get paid off first, and the highest interest will help also.

    Debt is evil and is a good investment to pay it off no matter what interest you think you can make in the stock market.

    Pay it down and pay it off fast!!

    You will be glad you did.

    Clint Lawton


  10. Mary Frances says:

    Just a quick correction: interest income from a saving account would be taxed at your ordinary income rate, not the lower capital gains rate. Only dividends and gain from the sale of capital assets gets the lower 5/15% rate.

  11. Four Pillars says:

    I think the argument that debt where the interest is tax-deductible is “good” or “ok” debt, really only applies if you are trying to decide which debt to pay first. If you rank all your debt from highest interest rate to the lowest then those rates should include any tax benefits.


  12. Excellent analysis, Trent. I like how you reframe paying down debt as a positive investment. I never could understand that argument of my friends’ that first and second mortgages were great tax write offs. People who run their own homebased businesses generate way more write offs than can be found in those burdens.

    I appreciate your insight and your ability to make financial affairs understandable. Your main premise, “Spend less than you earn…and master it” is the best piece of advice on all the personal finance sites. You provide a great resource for us.


  13. This is an excellent analysis. I tell my real estate investment students that while real estate investing appears to be a shaky investment, that the best thing to do with their money is to aggressively retire their high-interest debt.

    Bryan Ellis

  14. Although I agree with your points of paying off debt I don’t think we should fear debt and not use it to our advantage. Many people need to readjust the way the use debt (and not get into bad debt), but the shun using debt as a means to get forward will limit so many people in their future aspirations.
    You can still do all the things you said above (such as spending less than you earn and paying off debts) while using other debt to make you more money (which can be used to further pay off your total debts).
    Do both I say

  15. Jeff says:


    I know this post is about debt, but in your conclusion, you mentioned building an emergency fund. I take a little different approach than the standard 3-6 months of cash reserves philosophy. Maybe I’m just using my lack of that much reserve as an excuse for my logic but I’m curious what you think of the approach I’ve adopted.

    I have no debt other than the my home mortgage. No car payments, no credit card debt, no nothing. I save ~ 35% of my income per year which is split between maxing two Roths, funding two 529’s, contributing heftily to my TSP (govt 401K) and funding some cash savings in an Money Market.

    I don’t really think of the cash savings as an Emergency Fund. Its more like my “ah shucks” fund. Like “ah shucks” I spent too much this month, move some money over to cover us. “Ah shucks” the car broke down. While those might be emergencies to some, I just consider them the price of doing business. Sometimes the unexpected happens.

    Why do we need 3-6 months of cash expenses sitting around? I suppose if you were really worried about losing all income sources (i.e. your job) that might be a nice cushion until you can get back on your feet. But how often (I’m asking, I really don’t know) does that kind of Armageddon emergency happen? I don’t know anyone who has had a catastrophic job loss like that.

    In general my cash reserves are targeted for a specific purpose. E.g. a down payment on an investment property, a vacation, a new car, etc.

    I have an excellent credit history and currently have a couple credit cards that give me an available credit of close to $50K should Armageddon occur.

    My solution: A leveraged emergency fund should it be needed, a smaller “ah shucks” fund for those unexpected atypical needs, and the ability to attain other goals rather than tie up $35K-$50K just in case the worst happens.

    I like to think I’m managing my risk appropriately, but you and your readers may see it differently. I’d be interested to hear your opinions.

    I’m Minding My Own Business, are you minding yours?

  16. lastAutumn says:

    I have never thought that debt can be a good investment. It’s difficult to imagine something that forces you to save can be a good investment.

  17. Cheaplee says:

    A large consideration of debt is the risk of failing to pay it off. What happens if the “free money” becomes invested in a situation that in a year or so stops paying the rate it was suppose to pay, or the investment or project fails to deliver. That’s a big risk and even bigger consideration before using this approach. Lee, cheaplee

  18. Shareef says:

    Great post! I agree that debt repayment should come high on the list. I would put it even higher than 4, because sometimes you can’t spend less than you earn until a debt repayment plan is established and focused upon. This was my situation – my debts were exceeding the money that I brought in monthly.

  19. Spencer says:

    I agree that most debt is to be avoided (or eliminated as quickly as possible), particularly anything with interest rates 8%+. Where it gets trickier is lower rate debts, particulary those involving a home. If we continue to look at a mortgage and home through the lens of an investment, then you need to consider diversification.

    Diversification is the only free lunch available in investing (that why we like index funds so much). Someone who is risk averse (and therefore interested in the risk-free return available in paying down a mortgage) may actually increase their risk by becoming concentrated in home equity. The value of your home is tied to one property in a very local market, it has no geographic or other diversity.

    Of course this concentration makes it even riskier to by highly leveraged in your home (not enough equity), so you do have to be conscious of building a reasonable amount of equity. But after you are down to a reasonable loan to value (20% down payment or equity gets you there), your focus should be on diversifying into other investments.

    After you have built up a good diversity of investments, then home equity can be increased further, without becoming an overwhelming % of total assets. The goal is to avoid being “House Rich; Cash Poor.”

    This is the framework I am following. I recently got to 20% Equity in my home, and now I am focusing on building other assets, to drive my allocation to my home down to 15% or less of my total assets.

    Maybe a complex way to look at things, but if you want to view debt as an investment, then might as well go all the way.

  20. Ben says:

    Your points are well taken, but you are missing something in your comparison… and frankly I don’t understand how you would calculate for this, perhaps someone knows?

    If you have a loan in the amount of X and you pay the minimum + Y toward principle every month as you progress Y is going to ultimately be worth less and less. So you pay Y down on principle in month 1 and that saves you Z in interest throughout the life of the loan. In month 2 you pay Y down on principle which would be worth Z minus something?!

    So, depending on the interest rates, how long until your loan is paid off, how much you put on principle or into an investment vehicle, you may be better off putting Y into an investment even if the interest rate is lower depending upon the time horizon of the investment and the life of the loan.

    Does this concern make any sense to anyone else? Does anyone know how you would calculate for this?

  21. MoneyBlogga says:

    I’m visualizing a debt free life AND a much cheaper mortgage than I currently have and it’s looking sweet. When have I ever gotten into debt? To buy things I didn’t need at a much higher price than I should’ve paid to begin with. We’re looking to make a complete 180 turn in attitude because we don’t want to live like this any more.

  22. Ann says:

    Can’t disagree with living within your means being No. 1. But building an emergency fund and retirement before paying off debt needs some qualification.

    For emergency purposes, which is better –

    (1) to have $2,000 in a savings account earning 2% interest and a $2,000 balance on a credit card charging 8%, OR,

    (2) to have a credit card with a zero balance but $2,000 available credit and zero money in the savings account?

    For use in an emergency, you have $2,000 available either way. But you’ll pay a $120 premium in interest under option 1, plus the risk of an occasional late fee of $25 or more if you forget to pay it on time.

    Besides those costs, having high credit availability (unused credit line) versus credit debt will increase your credit score, whereas savings in the bank won’t. Higher credit scores can lower your car and other insurance rates significantly (my car insurance company gives 10% to 30% discounts for higher credit scores, which can save $100s of dollars a year), as well as lowering the cost of future borrowing.

    I would stock my pantry and keep a month’s worth of cash (for food, gas, etc., in case of major disruptions) on hand (not in the bank) and then focus on paying down the debt, before I would build a six month emergency fund. Think of the growing credit line available as the emergency fund – at least until all high interest debt is paid off. THEN I would work on my six-month fund of money in savings.

    Likewise, building retirement before paying down debt only makes sense in some situations. Someone whose company 401(k) plan will match her own contributions and who is in a high tax bracket should certainly do that rather than pay off student loans or credit cards, but someone with no matching program and a zero marginal tax bracket would be better off paying down debt. I think you simply need to do the math.

    Spencer makes an excellent point about diversification of investments. It isn’t only an issue of having too much of your net worth in one asset (home equity), it is also being over-concentrated in one geographic region, especially if your job is at all dependent on the local economy or your employer is a major employer in the area, and even more so if your retirement account is over-invested in your employer’s company or you have a defined benefit pension. A regional economic slow-down or bad year for your employer then carries a triple whammy: Possible job loss, home value deterioration, company stock/retirement account deterioration.

  23. RA says:


    “You shouldn’t pay down your mortgage or your student loans because of the tax benefits!
    Yes, some debts have tax benefits and those should be looked at carefully – but not overinflated. On student loans, you can deduct the paid interest each year, but all extra payments will do is reduce the amount of interest you pay in future years, just slightly reducing your deduction there.”.

    I have a student loan of 10K at interest 8.25 % in Canada. I was thinking of making large lump sum payments of 2k every 2 months( after keeping some money for emergency). Is this quote saying that it is not worth making lump sum payments as fast as I can?

    Appreciate any advice.


  24. Sharon says:

    Jeff asks: “Why do we need 3-6 months of cash expenses sitting around? I suppose if you were really worried about losing all income sources (i.e. your job) that might be a nice cushion until you can get back on your feet. But how often (I’m asking, I really don’t know) does that kind of Armageddon emergency happen? I don’t know anyone who has had a catastrophic job loss like that.”

    Hi, I’m Sharon.
    It’s true that kind of money is rarely needed but wonderful if you have it. I didn’t have this year, but was saving because I am a teacher and I didn’t want to work this summer if I didn’t have to. So I started saving. And I kicked out my roommate mid Feb so I could move during Spring break and reduce my expenses. (roommate wasn’t paying half and wasn’t paying on time). I knew I could get a one-bedroom and be more secure about costs (not pay the heat bill) and pay about the same or less than I was paying with the roommie. Such a good plan.
    Doctor found a “mass” in my belly in early March so I ended up taking all the rest of my sick days and my Spring Break doing fun things like having a colonoscopy.
    Now I could afford the two bedroom apartment I was in…just that my savings rate went to almost nothing. And there were all those pesky co-pays and things like laxatives for the colonoscopy to pay for.
    About the same as I found out for sure that the tumors were benign
    For non-stated reasons, my school decided to not renew my contract in September. If you are non-tenured they can do that.
    So, I was left with no job money after June, a question of whether to have a surgery to remove the tumors in July, and whether I qualify for un-employment.
    Because I had six weeks of expenses saved (at the cheap apartment rate), I chose split a plane ticket for my mother to come out to help me move and be around after my surgery (no health insurance after Aug 31…when it became a pre-existing condition) and I took about two and a half weeks before going back to an old part-timeish job..after all moving costs money as well.
    I am lucky that this bad paying job doesn’t require a huge amount of labor so I can go part time for a few weeks until I am 100%. NOw that I am feeling better (I’m still not feeling great, but I am surviving.), I am increasing my hours.
    So, my goal is to look for “a real job” while doing the “part-time job” for about 50 hours a week. Yes, it is crazy, but I think I can do this
    It beat lying to the state during the month of July that “I was able to start work at anytime” I’ll work hard to be honest.
    And that saved money gave me options to work with so that I could do everything I needed. As soon as I get “a real job” my goal will be that three months of expenses. Being able to take off the whole summer and just look for work would have been great.
    You are right that this is rare, but if you add in other issues like illness, I am guessing it happens for than anyone would like to think.

  25. Stephanie says:

    I think that pre-paying a mortage is almost never a good idea. The actual value of pre-paying a fixed-rate mortgage involves computations we don’t usually think about.

    Before you pay down a mortgage, you must look closely at the tax deductions you’re receiving. This calculation requires you to be comfortable with “tax math” and understand how federal and state income taxes work. Thus, most people don’t actually do the math.

    In general, if you have a high income and high state/local taxes, you are receiving the biggest benefit from the tax deduction.

    I did the calculations for my family. I found that state income taxes and property taxes pushed us over the standard deduction. Thus, all mortgage interest we pay is fully deductible. Further, we are in the 25% marginal federal bracket and the 6% marginal state bracket (and the same amount of mortgage interest is fully deductible from state taxes). So, our mortgage has a 6.375% interest rate. Our “after-tax” interest rate is 69% of that number: 4.39875%

    Pre-paying a mortgage is a long-term investment. In my case, I’m in the first year of a 30-year mortgage and we have just built our dream home with no intention of ever selling it. So I don’t get the benefit of the investment in my mortgage for years. If I pre-pay and cut 10 years off my payments, then I get a return in 20 years. My return is the future payments I don’t have to make for years 20 – 29.

    But those payments are worth less in 20 years due to inflation. If I have a mortgage payment of $2000 and inflation averages 3%, then that $2000 payment is worth $1088 in 20 years. In 29 years, that payment is worth $827.

    This means that as you contine to pay the same fixed-rate mortgage payments, the amount you pay is worth less to you as inflation decreases the purchasing power of $1.

    By the time your mortgage pre-payments result in a benefit, you will likely be paying more for property taxes than for the mortgage itself.

    The only way to get a short-term return on a mortgage pre-payment (without selling) is to re-finance the mortgage. This is risky because you are betting that interest rates will be the same or lower than your current mortgage and that you will be approved for a re-finance.

    Instead, consider putting the extra principal payments into a stock index mutual fund and hold it. Once that amount equals the remaining principal on your mortgage, cash in and pay it off. By long-term holding an index fund, you reduce your capital gains tax. You continue to get the full available mortgage tax deduction while growing the mortgage pay-off funds. The return is highly likely to exceed the after-tax mortgage rate (though it’s not guaranteed–that’s the risk you accept to get that return). And, that investment is liquid. If you need that money, you can get it.

    Am I doing that? No. I have too many short-term goals right now that are more important than future mortgage payments.

    Sorry for the length of this comment, but I just had to point out that a 30-year tax-deductible mortgage is an entirely different kettle of fish from credit card debt and car loans.

  26. gr8whyte says:

    Where to put your cash is complicated. Some say retire debt; some say invest it. Some financial planners even recommend borrowing “dead equity” from your home and investing it in the stock market (problematic had you done so before the recent crash). It all depends on your taste for risk and the opportunities available to you. Some years ago, Japanese banks could borrow billions of yen from the BOJ for next to nothing, invest in US bonds at a good interest rate and make essentially risk-free profit (minus currency exchange fees). I’d do the same in their shoes but I’m not so I chose to retire my mortgage early instead because my home isn’t an investment to me. It’s for living in while I’m on this planet. If I make a profit when it’s time to sell, great but I’m not counting on it and I don’t even include it in my net-worth calculation. Should stuff hit my financial fan, I’ll always have a home to come home to no matter what happens.

  27. john says:

    I agree with your list of top 4, except I can’t imagine why you would have an emergency fund as number 2. Given that it is an emergency I don’t see it a problem at all to count on credit card debt for emergency fund – particulary if you have showne yourself to be someone who doesn’t spend more than they earn and who can pay down debt. I just don’t see the value of emergency fund anymore – it is akin to burying money in a coffee can in the back yard.

  28. Zach says:


    What you are doing is 100% correct. Don’t change it.

  29. Eric says:

    I really like the philosophy of paying debt as a good investment with no risk- simply because it provides me that much more incentive to pay down debt!

    My question is, what is an easy way to calculate my ‘profits’ from paying debt? It would be so cool to have a spreadsheet where I have my credit card payments listed and put against my outstanding balance, and then using the interest rate have a cell that contains a ‘total earned’ or ‘total saved’ category. I think part of the reason people don’t always pay off debts is because in the short term there is no reward. But this could help offset that.

    What do you think?

  30. Han Solo says:

    Just ask yourself these simple questions:

    – Would I BORROW money at 19% on my credit card to invest it? If the answer is no(you hav a brain), then pay off the debt.

    – Would I BORROW money against my house at 9%(that second loan to pay for the home improvements you still have to pay off) to invest might also be a question for some people to ponder?

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