Should I Pay Off Debt or Invest?

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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