Should You Pay Off Your Debt or Invest?
Deciding Between Paying Off Debt and Investing Money Made Easy
A common situation people face when entering the workforce or getting serious about taking control of their money for the first time is making a decision between paying off their debt or investing. Both are admirable and necessary. Paying off your debt means reduced stress, lower risks, a greater ability to withstand personal emergencies or macroeconomics headwinds, such as a recession or depression, and increased flexibility that can maximize personal happiness.
Investing means building a reserve that can protect you and your family during life's struggles, generating what you hope turn out to be ever-increasing sums of passive income from dividends, interest, and rents, supplying resources to productive enterprises that create jobs and increase standards of living for your fellow citizens.
What should you do? Theoretically, the most intelligent course of action when deciding between paying off your debt and investing should be to compare two variables:
- The rate of after-tax interest you are paying on your debt
- The after-tax rate of return you expect to earn on your investments
Those who subscribe to this school of academic purity would say that answer to the debt reduction vs. investing problem can be solved with this one statement: "If you can earn a higher after-tax return on your investments than the after-tax interest rate expense on your debt, you should invest.
Otherwise, you should pay off your balance." An illustration would be billionaire investor Warren Buffett purposely carrying a mortgage on his home in Omaha, Nebraska up until recent decades because he knew he could put the money to work elsewhere in his investment portfolio and make a lot more in the long-run.
However, this is not always optimal once you've considered risk-adjustment. Instead, many financial planners these days recommend what I consider to be a more intelligent set of guidelines that provide the best of both words.
A Suggested Hierarchy for Which Debts to Repay and Which Investments to Fund
Here's how it would work.
- Fund any retirement account you and your spouse have at work, such as 401(k) plan or SIMPLE IRA, up to the amount of any free matching money you receive. For many companies, matching amounts range between 50% and 150% of the first [x]%. (The best 401(k) plan in the United States at the moment is offered by energy giant ConocoPhillips, which matches a whopping 900% on the first 1% of salary an employee saves for retirement.)
- Build your emergency fund in a highly liquid, FDIC-insured checking, saving, money market, or comparable account.
- If you meet the eligibility guidelines, fully fund a Roth IRA for both you and, if you're married, your spouse. You'd need to check the contribution limits in effect in any given tax year. For example, in 2015, a married couple earning less than $183,000 in adjusted gross income can contribute up to $5,500 of earned income per spouse ($6,500 per spouse if 50+ years old).
- Pay off any high-interest credit card debt, student loan debt, or other liabilities. Personally, I'd probably prioritize student loan debt because it can be the most difficult to discharge in bankruptcy. If something went wrong, being rid of it first could allow you to walk away in the most advantageous position. Keep at it until you are debt-free and stop adding to it at nearly all costs.
- Circle back around and contribute to your and your spouse's 401(k) accounts up to the maximum amount permitted by your plan or the tax regulations.
- If you're really serious about retirement saving, look into a strategy that involves using HSA (Health Savings Accounts) as another type of de facto IRA on top of your Roth IRA.
- Begin building assets in fully taxable brokerage accounts, dividend reinvestment plans, directly held mutual fund accounts, or even buying other cash-generating assets that are within your area of expertise; e.g., a real estate investor could purchase apartment buildings, office buildings, industrial warehouses. Alternatively, you might consider funding a college 529 savings plan for your children and/or grandchildren.
Major Advantages to Paying Off Debt vs. Investing Conundrum
By behaving this way, you achieve several things:
- You minimize your tax bill, both from earned income and on investment income, which means more money in your own pocket.
- You create significant bankruptcy protection for your retirement assets. Your employer-sponsored retirement plan, such as 401(k), has unlimited bankruptcy protection under the current rules, while your Roth IRA has $1,245,475 in bankruptcy protection as of 2015. You should not be draining these accounts, in most cases, to pay off debt. If you have to go nuclear and declare bankruptcy, you want these assets there for you the moment you walk out of the courtroom, chugging away more wealth so you can retire in comfort.
- You reduce your debts over time. There comes a point at which they're entirely repaid and your free cash flow goes through the roof.
- You only make riskier investments in taxable accounts once all of your other basic needs are met. For example, if you have a lot of debt and a small retirement account, you probably shouldn't be investing in IPOs.
Conservative Investing Approach to Paying Off Debt vs. Investing Problem
Alternatively, there is another way to behave that can be highly intelligent under the right circumstances and for the right type of psychology profile. This is to be completely debt-free, drawing a line around your assets so you never have to worry about having them taken from you short of a low-probability event. I know of people who eschewed any investing at all until they owned their own home, outright, paid off college, and had built an emergency fund working ordinary jobs throughout their twenties and early thirties. By the time they were approaching middle age, they had a foundation that allowed their investable assets to soar, totally unrestrained by the financial demands that seem to haunt certain individuals and families in perpetuity. In other words, their answer was to always pay off debts first, then — and only then — begin saving.
You may not realize how common these people are but they exist. In fact, 1 out of 6 homeowners under the age of 44 years old has paid off his or her mortgage entirely (a majority of homeowners have by the time they are senior citizens), 1 out of 2 Americans has no credit card debt, and 2 out of 5 college students have no student loan debt with the remaining 3 out of 5 owing far less than the media would have you believe due to a failure to differentiate between median and mean. While some of these are the result of inter-generational assistance (e.g., wealthy families helping out their own), it's a far lower proportion than you might think. In fact, at this moment, the inherited rich make up the lowest percentage of the wealthy they ever have in global history. It doesn't fit the narrative you're fed in the nightly news but it's the truth.
In reality, it is not normal to live broke and die in debt in the United States. If you do, it is operator error; you screwed up unless there was some sort of medical emergency or unforeseen disaster that was beyond your control. Why aren't these self-made folks talking? Why aren't they telling you that they not only paid off their debt but they also invested? It's a phenomenon known as stealth wealth. Nobody wants to be the 38-year-old jerk at the dinner table who says, "Yeah ... we have a six-figure portfolio, paid off our house, have an ample emergency fund, and quietly take vacations we don't tell you about" even though such an outcome isn't all that rare. People truly have no idea how much money is surrounding them because it's largely taboo to discuss. Try explaining to someone that we've now reached a point where 1 in 5 American households earns a minimum of $8,333 per month and they likely won't believe you. Our affluence as a nation is truly obscene. (If you want to be amused, watch the reaction of someone from another affluent Western nation, such as Ireland, when you tell them that by some U.S. Government metrics, a married couple with two kids is considered living "in poverty" here at the equivalent of a household income of €40,500. Few have any idea that this is what our politicians are talking about when they discuss American socioeconomic struggles.)
The Bottom Line: You Are the Variable That Matters
In the final analysis, my opinion is that behavioral economics needs to be factored into your decision. You have to make a decision between investing and paying off debt that 1. you can live with, 2. you're likely to stick with until it's completed, and 3. lets you sleep well at night. As long as you keep going, you should eventually get to the end-game objective, which is to have no debt and an abundance of great, lucrative investments providing a comfortable standard of living for your family. With enough patience and hard work, this is a goal that you can achieve.