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?