A close friend of mine asked me the following question: “My wife and I both have some student loan debt and a mortgage, but we would like to begin investing. Should I prioritize paying down the debt, or investing?”
This is a common question, and many blog readers struggle with making a similar decision. My answer was not straightforward, because there are several different possible solutions that depend on personal preference.
- The rational answer is to choose the option with the highest expected payoff. More simply, choose the option with the highest interest rate. If your debt interest rate is higher than the expected return from investing, pay off the debt first. If the opposite is true, pay the minimum amount each month on the debt, and invest the rest.
- The behavioral answer is more complicated, because debt carries an emotional cost. If you despise debt, you might prefer paying down the debt regardless of the interest rate.
- Or, consider a hybrid approach where you invest and pay off the debt simultaneously.
If you desire a more detailed approach, continue reading.
1) Automate Minimum Payments
When dealing with any type of debt, the first step is automating minimum monthly payments. Doing this prevents late payment fees and other penalties.
Set these payments up through your bank account, or directly with each creditor.
If you are having trouble staying current on all of your debts, consider consolidating or restructuring your debt.
2) Create Liquidity (an emergency fund)
You want to set aside cash in a liquid checking or savings account that is easily accessible. The common recommendation is to set aside enough money to cover 3-6 months of expenses, but choose an amount that makes you comfortable.
This money prevents you from accumulating more debt in an emergency situation.
3) Take Your Employer Match
If you have a retirement plan at work, does your employer offer to match your contributions? If so, then you should participate and take advantage of that free money.
An employer match typically looks like this:
You’re earning $50,000 per year. If you contribute 5% of your pre-tax income to the 401(k) at work, you will have set aside $2,500 for the year.
If your employer offers a 1:1 match, they also set aside $2,500 on your behalf. Your total account balance is now $5,000. That’s a 100% return on your investment, with zero risk.
Even if your employer only matches half of your contribution, that’s a 50% return. You cannot beat an employer match, because it’s risk-free money.
The one caveat here is your employer’s vesting schedule. Some employers require that you work a minimum number of years before the match money is legally yours. You need to check your plan to view the vesting schedule.
4) Pay Off High Interest Debt
Some forms of high-interest debt should be prioritized before investing. For most people, this includes consumer debt (such as credit card debt) and unsubsidized student loan debt.
If you are wondering why I recommend prioritizing the debt, consider the following reasons:
- Most experts are expecting less favorable investment returns in upcoming years. Stock valuations have climbed much higher than the historical average, which is expected to reduce future returns. Furthermore, bond yields are near all-time lows, and interest rates are expected to slowly trend upward. This combination could result in a low-yield environment for many years. In such a scenario, expect a balanced portfolio to yield much less than the historical average (5-6% is a common long-term estimate).
- Investing in financial markets involves much uncertainty, and there are no guaranteed returns. Most financial assets are risky, and the stock market can be extremely volatile in the short term.
- Paying off your debt is a guaranteed return. If your debt carries a 9% interest rate, repaying the debt results in a guaranteed 9% return.
When deciding between debt repayment and investing, you should compare the expected return of each. Because debt repayment provides a guaranteed return, you should compare against a “guaranteed” investment, such as a short-term bond or savings account.
Treasury Bonds are often considered the “risk-free” asset because they are backed by the U.S. Government. Short-term bonds are much safer than long-term bonds because of interest rate risk. As interest rates rise, the present value of a bond falls. So a fair debt comparison might be a short-term Treasury Bond or savings account.
A high quality savings account yields about 1% in our current environment. A 1-year Treasury bond yields less than 1%. Even riskier bonds (such as the 10-Year Treasury) are yielding less than 2.5%. That’s a scary low yield for a 10-year investment.
As you can see with the numbers above, no investment in our current economic environment is going to offer you a guaranteed return in excess of 5%. As a result, I think 5% is a reasonable estimate for “high interest debt.” You might disagree slightly with the numbers, but you should view your debt as a guaranteed return when making relevant comparisons.
For the more technical readers, you should be comparing the after-tax return of both options. Some forms of debt (i.e. mortgage or student loans) are tax-deductible, lowering the effective interest rate. Unless held in a tax-sheltered account, most investment income is also taxable, lowering the after-tax yield.
For example, let’s assume you are in the 25% tax bracket and itemize your tax deductions. If your mortgage carries a 5% interest rate, the after-tax rate is 5% – (25% * 5) = 3.75%. If you invest in a savings account offering 1%, your after-tax yield is 0.75%. The difference between the nominal rate and effective rate increases with your income tax bracket.
5) Decide How to Handle the Remaining Debt
Above, I suggest 5% as a reasonable estimate for high interest debt. If you disagree, you need to identify a reasonable estimate for your situation.
At the other end of the spectrum, some debts carry very low interest rates. If the rate is below 2-3%, you might consider retaining the debt and investing instead. This is especially true if you are able to make additional contributions to tax-sheltered accounts.
Debts that carry an intermediate interest rate (in my example, between 3-5%) are a matter of preference. In such a scenario, choose what makes you happy. If you like the idea of being debt-free, pay off the debt. If you feel indifferent, split the difference.
Summary and Conclusions
The steps outlined in this article can help you decide between investing and paying off your debt. You might disagree with my definition of “high interest” or “low interest” debt, but that’s a matter of personal preference.
In the end, the optimal decision is a function of your rational and behavioral preferences. The rational decision is the one with the highest expected payoff. The behavioral decision is the one that makes you happy.