A few weeks back I told the story about how zero out of thirty of my peers are investing outside of a 401k. In that post, I ran a poll of the top reasons why people are not investing outside of a 401K. I also promised to follow up with a series of posts to address each of the roadblocks mentioned. This is the first in the series of posts.
In the poll, 25% of respondents indicated that they were paying off debt first, before investing. This was the second biggest vote getter as to why people were not investing.
A lot of people struggle with the question of whether or not they should take money that they have earned and use it to invest or pay off debt.
As a general rule of thumb, it is usually good strategy to pay down debt first versus investing money. But not always. I’ll take you through an analysis of how I’d approach this decision.
Guaranteed Investment Returns are a Rarity
One unique situation where it might make more sense to invest than pay off debt is with a 401K match.
For example, my employer matches 50% of my 401K contribution. Some employers match up to 100% or more. Either is a guaranteed rate of return that is going to be higher than the APR on just about any type of debt you could have (excluding payday loans).
True, this is not ‘investing outside of your 401K’. And yes, you are sacrificing the present for your future and if you’re in too much debt there could be additional consequences to consider. But if your debt is manageable, it might make more sense to take the guaranteed returns.
What is the APR on Each of your Debts?
Once you have squared away your 401K match, you should then jot down the interest rate, or APR, that you are paying on each of your debts.
Hypothetically, let’s say that it looks something like this:
- credit card: 12%
- auto loan: 7%
- mortgage: 5%
- student loan: 2%
These are the four most common types of debt that people have.
If you don’t pay off your auto loan or mortgage, you won’t have your house or vehicle for long. So we’ll assume in this post that ‘paying off debt’ means that you are already paying off your required minimum payments and any additional debt pay-off is against the principal.
What Average Investing Returns Should we Assume?
This is a tough one because there are so many ways you can slice historical investing averages data. And, there are no guarantees in investing. From 1950-2009, the S&P 500 index (top 500 companies) had an average annual return of 11%. Of course, over the past 10 years, we’ve seen an average return of just 1.5%.
However, we can’t really compare the past to the present or future. The industrial and technological advances that resulted in an economic boom and 11% growth in the markets over the previous 60 years likely won’t be reproduced over the next 60 years.
So, perhaps we assume a conservative 5% average annual return, which can be achieved via dividends from high dividend paying stocks. Your actual returns will vary, but barring major catastrophe, a 5% return does not seem overly optimistic. Use whatever number you’d like to do your own assessment.
Compare the APR on your Debt to a Very Conservative Investment Return
Time to compare investment returns versus debt. What’s not always intuitive is that paying off debts you’ve already assumed, in many ways, is like guaranteeing yourself a return on investment (versus not paying them off). Putting additional funds toward an auto loan that pays off the final year of that loan effectively would guarantee yourself a 7% return on investment vs. continuing to pay the loan interest over that year, for example.
In other words, not paying off your debt presents an opportunity cost.
With that in mind, let’s look at each of those four debts again and analyze each individually against a potential 5% annual return if we were to invest the money:
- credit card: 12% – this is a no brainer. If you have credit card debt, you should probably take non-retirement funds that you’d be putting towards investments and using those funds to pay off your debt. 12% is on the low end of credit card interest payments – some go as high as 22% or more. Whether it’s 12% or 22%, you would be considered extremely lucky to achieve that level of annual return through investments over time. Pay off that credit card debt.
- auto loan: 7% – some auto loans can be lower than 7% via a special promotion, but this is about the average that I have seen advertised. I would rather take a guaranteed 7% return than chance my money in the market, but that’s just me.
- mortgage: 5% – this is a tricky one. When your debt carries an interest rate that matches up evenly with a conservative investment return, you can really go either way. It becomes more of a lifestyle choice than anything else, in my opinion. Do you want to carry that debt and the stress that comes with it, or do you want to try to get better returns, which you could then put towards the debt? I don’t think there’s a right or wrong here.
- student loan: 2% – my wife still has student loans that have a 2% APR. We will never pay more than the minimum payment required on these loans. I’m fairly confident that I could find investments that would return better than 2% (which is less than the rate of inflation in many years).
Debt Payoff vs. Invest Discussion:
- How have you approached this decision?
- Do you agree or disagree with my approach?
I never quite know what to do in this situation. We don’t have “debt” the way other people mean credit cards and student loans. We just have a mortgage and two car loans. The cars are both at 3.9% and the house is at 6.5%. With the cars being so low, and lower than the mortgage, I don’t think it makes any sense to pay them down. The mortgage is right on the cusp of a realistic investment rate of return (or one I think I can probably beat), but it’s also guaranteed. The thing that stops me from sinking all the extra into it is that the house is treading water, with signs that it will continue to sink further underwater. We can afford it and don’t have any plans to walk away, but should something drastically change, I’d hate to think we sunk money into it only to kiss it all away.
I was paying an extra $350 a month to the mortgage, but have pulled back. What do you think our best move in this situation would be?
Might be time to refinance that mortgage.
Good article! Though I bet most peoples student loan rates are beginning to eclipse their mortgage rates.
I agree. I have a couple private student loans that I got that are 9%. My feds are only around 3% which is nice.
My only debt right now is student loans, 250,000 at 6.9% (thank you medical school), but I still opt to max out my 401k and Roth IRA each year. I think if it were after tax money that I was investing things would be different as 7% is a pretty good return on investment. However, with tax advantaged accounts it seems like the extra boost you get pushes my expected rate of return over the 7% threshold. I have not done the calculation to come out with a annualized return percent that the tax advantage offers but would be pleased to be directed towards someone who has.
With regard to above comments, 1) I don’t see how mortgage “debt” and auto loan “debt” is any different than other kind of “debt”; you are still borrowing money to buy a product or service that you could not afford at the time you wanted it and paying a hefty price to do so in the form of interest. 2) I wish that I was in school back in the days of 2% interest.
I agree, debt is debt. But most discussions offering advise on how to handle debt aren’t really referring to mortgage and auto loans, and people constantly have stories of paying off their debt when they really mean credit card debt, but still have auto loans or credit cards.
It just makes it a little harder to figure out the right steps with regard to investing versus paying debt, especially when the rates are low enough that I might be paying a heftier price by giving up potential return on invested money.
Debt is debt. But some is no doubt worse than others.
Wow, that’s a lot of student loans. I hope you REALLY love your job!
I couldnt justify or advise someone to pay down their mortgage and not invest… investing is part of reaching medium term – long term goals, and as a means for a safety net. I would certainly advise in many dividend stocks/funds over putting money into a savings account so that you build your emergency fund a little quicker. But you cant just take all your extra income and throw it on paying down all of your debt… there are tax advantages, and money is needed for a rainy day.
That’s a good point. And there’s no rule that you have to entirely do one or the other. Much like a diversified investment strategy, you could consider splitting between the two a diversified strategy as well.
We have $150k in Credit Card and Personal Loan Debt with an average APR or about 15%. The interest has been killing us more than anything.
We have $150k in Student Loan Debt.
We have a mortgage balance of $414k on a home worth $450k.
We have nearly tapped every possible resource to try get additional loans or balance transfer to get a lower rate of interest to at least knock out the Bad Debt.
However, we are also looking at a tax obligation for the tax year 2010 in the ballpark of $10-$15k…of which my only option is my Chase card which happens to be my only card left with a balance capable of covering this obligation, but at 29.99%.
We make a good amount of money, roughly $250k, but have obviously made some bad decisions and need to use our high income to pay down these beasts.
Bankruptcy is not an option as I have a Secret Clearance and need to maintain it. Also, I’m afraid to consider Tax Payments with the IRS as they may also trigger a closer look into our financial situation…what are your thoughts?
Any advice would be greatly appreciated.
There’s no reason not to choose tax payments if you need them, it won’t trigger an audit. However, the IRS is completely unforgiving if you do not make your payments on time. If you miss or make a late payment they will stop the payment plan, make it all due immediately and disallow you from ever signing up for another one. So be very careful about following through with payments.
Get divorced, leave everything to your wife, have her declare bankruptcy, move into an apartment, get married again, bus or bike to work, and start your financial live from scratch?
I graduated last May but took until november to find a job. I’ve been wondering about this question as well. I have 17k at 7.25% and 6.5k at 5% in loans (already paid about 5k). My plan is to put in 600 a month total for loans and also max out 401k contribution. I have enough to put in 5k to Roth IRA sometime this year (I’m not sure which company is best for this and how to get started with picking the right stocks/funds/etc). This leaves about 8k extra between a new car, investing in stocks, or paying off loans which I’m not sure how to split up yet. There’s a good chance my current car will die on me soon, but assuming it lasts another year where should the 8k go?
Another concern is that I want to retire early so I’m not sure if putting in 10k or so a year for retirement payouts that won’t occur until 60 is a wise move.
Wow. I thought I had it bad but after reading all the comments, my only debt is still the mortgage. We recently refinanced into a 15-year bi-weekly loan for $110k at 4.375%. Prior to that, I was already 9 years into a 30-year loan but at least I had gained $43k closer to paying it off during that time. And because of that, my monthly payments are a lot cheaper now.
I have no surplus money to invest other than the paltry sum I put into my 457b and a bit I save into my savings every paycheck.
You have to factor tax advantages in all this, too.
For example, if you’ve already maxed out your tax advantaged accounts, so the choice becomes investing in a taxable account vs paying a car loan off, remember you’ll have to pay taxes on the money you make on the investments (if any), but you won’t have to pay taxes on the interest you saved by paying the car loan off, so that would encourage you to pay the car loan off.
Also, you get some legal protections with some choices. For example, 401k and IRA accounts are protected assets when being sued.
Another thing I consider is liquidity of the money with each choice, as well as when the opportunity is available. For example, I’ve recently struggled with this decision: should I pay my second mortgage off (8.625% interest), or should I max my Roth IRA first?
I decided to max my Roth IRA out first because I could do that and pay down the second mortgage. My reasoning was:
A. I get a tax credit on that second mortgage interest, so it’s more like 6.5% interest instead 8.625%.
B. I can make withdrawals on my Roth IRA if the proverbial crap hit the fan. Extracting the equity out of my house is next to impossible unless I sell it, and good luck with that in this market.
C. I have one opportunity per year to put $5,000 in my Roth IRA. I have up to another 25 years of opportunity to pay down my second mortgage early.
D. My Roth IRA is legally protected.
Sure, I won’t pay my second mortgage off as quickly as I’d like, but when I do, I’ll have an extra $20-30K in my Roth IRA.
Your approach is really good. I haven’t thought about this and I always went with paying my debts first before investing. But now I know that this approach can work.
I’m paying off my debt first because when the money I’m paying for debt is free, I can invest it :)
Good article. I generally think paying off debt is very important and should take priority over investing, especially in this low ROI marketing with tiny interest rates. We’re going to see the returns from CDs and other investment tools drop even further as the Fed is going to get closer and closer to -(negative interest) aka 0% interest rates. So pay off your debt and invest when you’re free and clear. ;)
I try to do a combination of both. I’m about to try to max out my 401k and see if I can take the squeeze. I just bought a house. It’s modest, but its perfect for me. I always pay triple the monthly minimum into my student loans. I have to try push myself to stay motivated sometimes though, since the loan amount is so big. I am, however, back in grad school, which my company is paying for 100% of!
I agree that it is not always wise to pay of the debt first and not to invest but one should only invest when there is almost no risk of failure in investment.
Max out your tax advantaged accounts (401k, IRAs, etc.) while gradually building 6-12 months paychecks worth in a savings account as a job loss contingency fund and a deductible fund for a large portion of your deductibles (think car insurance, home insurance, health insurance etc.).
Start a fund for your wedding, no matter who you are and how less you intend to spend, at some time you will have to and if it is more than 3 years away, invest this money with that goal in mind. If it is less than 3 years away, save it in a bank (online: SmartyPig is what I use). A healthy target is 15-25k in savings to cover ring, wedding, honeymooon.
Now if your debts are higher interest rate (upward of 6%) then pay a little extra towards the principal, if they are super high (upward of 9%) definitely pay a lot towards the principal. For less than 3% interest rate debt, just pay the minimum.
If you have money left after all this, invest it in the stock market based on your risk appetite. At this point a lot of risk has been mitigated and you can invest with a true long term eye (i.e. you won’t be forced to exit the market due to a small/medium unseen expense, possibly even a large expense and the timing of your exit will be your own choice).
The reason you should pay of debt faster is that it increases the chances that if you do need to dip into debt, you will likely not be denied due to the outstanding amounts and accounts.
I hope I was not all over the place here.
Paying off debt would be a guaranteed return on your money, whereas an investment isn’t. It all depends on the situation, but i think people don’t realize how much of their paycheck ends up going to interest. If it’s high interest credit card debt, i would definitely opt to pay that off first. Good article :)
The decision depends on the circumstance! For a few lucky ones investing may be a better option rather than paying off debt. In such cases, may be the investment returns can be used to pay off a debt. Supposing this is not the case with others, it’s better to concentrate on the debt repayments. In either case, a financial advisor can suggest the right way!
I have no debt EXCEPT for for $160K in student loans with a 2% interest rate.
I know that I SHOULD put all my money into investments and pay the minimum amount on my student loans but that $160K is just killing me. I don’t feel like I can consider buying a house, or taking ANY risks with it hanging over my head. I only make about $40K right now and max out my Roth IRA, but when I start to make more (in a couple of years fingers crossed) it’s going to be hard not to put every extra penny toward paying off those student loans. I’m looking at it this way: if I’m being tempted by something I don’t need (clothing, fancy food) and I tell myself – “Self, if you don’t spend money on that stuff you can invest it,” I know I’ll shrug and buy the clothing. But if I tell myself “Self, if you don’t spend money on that stuff, you can put that money to killing your student loan!” I will walk away from the clothing or fancy food, and go put a little more money to paying off my loan. It’s completely psychological for me. Paying off debt = FREEDOM.
I agree mostly, however as others have stated, there is definitely an emotional value to paying off ones debt, which may override certain financial values of keeping ones debt.
I also agree with the feel-good aspect of paying down debt. I’m at about $12K total debt, paying down around $1K a month, I even managed to put $1K towards my Roth this year as well. I could have put off my debt somewhat as it’s average around 4-5% overall, but I wake up feeling much better when the total debt starts shrinking.
i agree it is up to the person and sometimes if you are in the right investment you could be making a lot more than the average it all depends on the situation.
Ha! I’d like to see how many people out there are paying off student loans with 2% interest. The reality for graduates since the 1980s is more like 6-8 percent.
I hear you on the student loans, mine are at 6.8% and I just started repaying them at the minimum. After I finish paying the IRS and 2 other debts in Dec 2011, I’m going to go whole hog against the education loans using every trick in the book to reduce the total cost.
I would agree with your strategy. Maxing out the 401k contribution if your employer matches is a no-brainer. After that I would pay off debts starting with the highest interest rate debt. Next I would save for an emergency fund worth 3 to 6 months of expenses (maybe even 12 months). After that I would pay extra on my mortgage. I’m not saying this is right or wrong, just that this is what helps me sleep best at night.
It’s better to pay off your mortgage because with stocks you have to pay capital gains taxes and dividend taxes which diminishes your return.
Its better to get a guaranteed tax free return of 5% than to lose 37.22% which the s&p 500 did in 2008.
2% student loans are a mythical animal. Try 8.5% for government PLUS loans these days. Plus VARIABLE rate private student loans for graduate students that don’t qualify for full government loans. This is all NON-DISCHARGEABLE DEBT. Get rid of student loans ASAP so you don’t get stuck with them forever.
Agreed. I graduated in 2009 and my federal loans are at 6.8%. My private student loan with Chase is 5.1% variable, but the variance has been to my advantage in this economy as I have only seen decreases since getting the loan; it went as low as 4.9% and would be 5% now but I opted out of the automatic payment plan and lost the .1% decrease bonus.
But my strategy is to pay off loans first. Auto loans and mortgages are technically debt, but they are not “bad” debt to me; they have collateral and in the worst case scenario the banks could just take them back if you couldn’t pay – this is not so for credit cards and student loan debt. I currently have student loan debt of around $21,000 paid down from around $32,000. It took me two years of working and promotions to be able to afford more than the minimum payments, but starting this past summer I started chucking huge amounts of cash towards it. I have an auto loan around $15K, but I am not really worried about it since I can always just sell the car if push came to shove, and it is at a low rate of a little over 3%. No mortgage as I don’t want to get tied to any one area.
Hi Mr. Miller:
I am a freelance personal finance journalist for Reuters. I am planning to pitch a story to my editors on Monday, to be called something like: “Generation Y Dilemma: Pay Down Student Loans or Invest?”
I think your blogs are very well thought out and insightful, and would like to interview you for this story. Would you be available to do this? It would take about 20 minutes or so. (Please reply by e-mail)