Do I pay off my debt or invest?

This is a classic question that comes up most often and troubles a lot of people. I view this question as a spectrum where on one end is to be completely debt free and the other end is to be entirely leveraged (another term for taking on debt) to the hilt. There are folks at opposite ends of the spectrum and a lot of folks are somewhere in the middle. Like everything in personal finance, it’s personal – you have to decide what is right for you. So today my hope is this article offers you a framework to think about this. I am going to offer two different arguments. The first argument is the mathematical argument and the second argument I am going to call the ‘what-allows-me-to-sleep-at-night’ argument. What I do want to tell you right away is that I am not going to give you an opinion one way or another. 

However, before we dig into both of these arguments, I do want to offer a clear opinion on three things that you must do before you embark on debt payoff or investing:

1. Pay off your high interest loans first – There are debts that are extremely high interest debt like credit card debt or payday loans. When I talk about credit card debt, I am talking about the debt you carry when you don’t pay off your credit card debt in full and keep it revolving. Basically credit card interest is around 13%+ and paying that off is a no-brainer. There is simply no mathematical way to justify not paying off these extremely high interest loans. 
2. Get your emergency fund in place – In my article on Emergency funds, I have offered some thoughts on this. Get this in place before you embark on paying off any debt early.
3. Get your 401K free money – if you are employed and your employer offers you a 401K match, then meet at least the match because this is literally free money (it’s part of your compensation) that you would be leaving on the table if you did not do this. 

With that out of the way, let’s talk about the 2 arguments:

The Mathematical argument

Most typical conventional loans (mortgages, car loans, student loans) involve a payoff of Principal + interest each month. The question is whether you should repay more than the required monthly payment by which you can reduce the overall interest you pay through the course of the loan. If you want to look at it at a very high level and think of this simply, it’s this – if your interest to borrow is much lower than the rate of return you get by investing the money, then generally it makes a lot of sense to arbitrage the difference and invest the money. I know this is a controversial point especially amongst the Dave Ramsey followers who believe in a no-debt philosophy. The question Dave Ramsey asks is, “ Would you borrow money at 3% to go and invest in the stock market?” And more often than not, people will say No. However, the math actually says otherwise. Let’s examine this using an example for a mortgage:

Sam took a $200,000 outstanding mortgage at 3% interest rate on a 30 year fixed mortgage and his monthly Principal + interest payment is around $843.00. Now, after 10 years, he has $193,720 left on his loan and let’s assume hypothetically he has suddenly run into a lot of money and has $200,000 of cash available. He has a choice as to whether he should pay off the entire mortgage right away or invest that money in something else. So let’s do the math on both his choices. 

Now, compare the 2 choices. Clearly, he would have come ahead by making choice 1 because he would have made more money. To be precise, his benefit of making choice 1 is $330,000 – $94,000 = $236,000! So that’s how much money you left on the table by paying off the loan right away. This explains to you mathematically you are better off NOT paying off the loan right away. Now, this is a rather simplistic example and one thing to consider is the risk. It’s beyond the scope of this article to go into detail on risk but it is still pertinent to talk about it briefly. 

What about risk?

You could turn around and ask me the obvious question – is this 5% in the above example guaranteed? The answer is No. No investment in the true sense has guaranteed returns. All investments carry a certain amount of risk. So how should you then think about this? There are mathematical ways to think about risk using Standard deviation, Betas, sharpe ratios and so on. But I am going to offer you a couple of simple factors to think about this. My disclaimer here is that this is based on history and there is no guarantee here – but think about it in terms of probability. The probability of certain returns is higher or lower given the below considerations.

1. Time horizon – consider the time horizon you are looking at. When you are looking at a longer term horizon like 20 years as in the above example, the history suggests that the stock market returns are always positive and as a rule of thumb you can assume around 7% before tax returns (which could translate to around 5% after tax depending on your tax situation). If the time horizon is shorter – say 5 years – then I would say that the risk is a lot higher that you will not make these kinds of returns. So in general, the longer the duration the lesser the risk in something like a total stock market index fund.* Finally, one of the factors you will consider when you think of the time horizon is how far away you are from retirement. The longer the horizon, the better position you are in to take a risk. 
2. Diversification – the more diversified your portfolio, the lesser the risk. I will not go into modern portfolio theory explaining the optimal diversification and asset allocation. But think of it simply as this – if you invest all of the above $200,000 in one single stock, your risk is going to be extremely high vs if you invested in a diversified portfolio of stocks or simply an index fund. Ideally, you should be invested in different asset classes.This topic deserves its own article which I will write about later. 

So what are the mathematical thresholds when I can pay off loans or keep them?

The detailed example was simply to illustrate how you should do the math and think about risk. Depending on the prevailing interest rates in the market, what is considered high interest and low interest is going to be relative. I am going to offer my personal recommendation on these thresholds. But remember, this is my personal opinion and you can make counter arguments on this but think of this as a framework and don’t get fixated on the actual numbers. You can tweak the numbers based on your own research. These thresholds I show are based on my opinion on today’s interest rate environment (as of Dec 2020). A general rule of thumb is to reference these to prime rates. Current prime rate as of Dec 2020 is 3.25%.

Now, I do know real estate investors and hedge fund managers who argue they can still make north of 10% returns in today’s environments and hence may like to operate on very different thresholds, but those are typically not the average Joe investor like you and me.

What-allows-me-to-sleep-at-night argument

So we spent a fair amount of time looking at this question in a mathematical way. Lets now pivot and look at the more behavioral side of personal finance. Despite all the math telling me I should not repay my debt early or pay it off right away, my personal risk appetite will drive me to ask the question – What allows me to sleep at night? If I am someone who just cannot handle debt (can be a variety of reasons including a personal or family history of bad experiences with debt), despite having a very low interest loan, I may be better off paying off the loan. Nothing is more important than being able to sleep well at night, right? On the other hand, despite having different high interest loans, I might want to keep it all because my risk appetite is very high and I feel confident about being able to earn higher returns. In that case, paying it off early may prevent this person from sleeping well at night. 

Let’s examine the person who wants to pay off all the debt in a bit of detail because that’s the most common example. There may be some situations why this may still make sense for the person despite the math saying otherwise. One situation may be that this person is looking for an early retirement and wishes to have all kinds of debt out of the way, giving him/her flexibility when they retire. Another situation may be that you just cannot seem to get over the mental block of being able to invest without having all debts paid off. These types of folks simply cannot handle multiple priorities and so it may just make more sense for them to pay it off early. For these folks, I would encourage them to read more about Dave Ramsey’s baby steps to get off debt (https://www.daveramsey.com/dave-ramsey-7-baby-steps) 

Finally, I will say this – for a lot of people, getting more educated about the math I explained above as well as about personal finance in general, may help them feel more inclined to take on a certain level of risk. Often the lack of knowledge is what drives people to have risk-averse behaviors (or even unnecessary risk taking). If you are one of them, I would encourage you to read up more and educate yourself. The behavioral aspects of personal finance is the one most ignored but probably has the most impact on a person’s financial success. 

Thank you for reading and I hope this article helps you get started in your decision making on paying off debt vs investing. I wish you success in your financial well being.

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice. 

*Using Vanguard’s total stock market index fund VTSAX, you can go to https://www.morningstar.com/funds/xnas/vtsax/risk to see the risk expressed through one of the measures – Standard Deviation. Standard deviation goes down when its 3 years vs 5 years vs 10 years.