On our financial freedom webinar, we stress the importance of focusing your financial efforts on one goal. The top question we then get is, “Should I pay off my debt or invest?”
This isn’t a straight forward answer as there’s a lot of variables at play such as:
- What kind of debt you have;
- The interest rate on the debt; and
- Most importantly, what are your goals.
In this article, we will be going over the steps to help you decide whether you should be paying off your debt or invest first.
Types of Debt
Financial freedom starts with understanding. Therefore, to answer the question of paying off debt or investing, you need to understand that debts are not created equal.
There are quite a few different types of debt. However, we are going to focus on one type because its the most important in answering the topic of this article.
Secured vs Unsecured Debt
Secured debt is backed by some type of asset. Examples of secured debt include Mortgages and Auto loans. If you fail to make payments, the lender can take over your asset as the collateral.
Unsecured debt is back by your word to repay. This includes debt such as student loans, credit cards, medical bills, and personal loans. Unsecured loans come without collateral. Therefore, they are generally higher interest rates when compared to secured debt.
Steps In Deciding To Pay Off Debt or Invest
Below are the steps to decide whether it’s a good idea to pay off your debt or invest first.
Step 1 – Identify What Loans You Have
First and foremost, get an idea of all of the type of loans you have such as a mortgage, student loans, and/or credit cards. This helps you identify what we refer to as qualitative risk.
Qualitative risks doesn’t look at numbers it looks at logic and how it applies to your financial plan.
For example, you can’t discharge a student loan in bankruptcy. Whereas other debts you can. Therefore, student loans are more risky to your financial plan, all else equal.
Also, for secured debt you can sell and get rid of the debt. Whereas you don’t have anything to liquidate to pay off unsecured debt. Therefore, unsecured debt is more risk, all else equal.
A mortgage loan for example would be backed by the house. You can walk away and get foreclosed on or sell the house. Regardless, you are no longer liable for the loan.
Step 2 – Knowing the Risk vs. Return
This is where we start looking at the decision of paying off debt vs investing from a quantitative view point or what we refer to a risk vs return point of view. This centers around the interest rate on your loans.
First Things First
Investing naturally comes with a certain set of risk involved whereas paying off debt is risk-free.
For example: If you have a loan that has a 6% interest rate and you pay it off, you no longer have to pay that interest rate. That is essentially a risk free return of 6% in your pocket.
Therefore, from a risk return perspective you have to compare paying off your loans relative to the risk free rate of return.
Right now the risk free rate of return is about 4%. Therefore, from a pure risk vs return perspective, if your interest rate is above 4% then you’re better off paying down debt.
That is when I typically get the question of, “Well the stock market returns x%. Why not look at that?” You can but you have to look at it from a risk vs return perspective which I explain next.
The Stock Market Plays A Role
The first mistake people make is they say the stock market returns x% on average. They are right, it does. However, there are two items to point out:
- That is over the long-term such as 30 – 40 years. There are plenty of examples of 10 year stretches year the S&P500 returned 0%. Therefore, when making this comparison you have to look at how long your debt repayment is. I.e. if your loan is a 5 year loan you have to compare that to the risk that during the next 5 years the S&P500 returns less than the interest rate on your debt.
- How much more is the expected return of the stock market relative to your interest rate on debt. For example, if I have a 30 year mortgage at 8% and I think the market is going to return 8.5% over thirty years, is the extra .5% really enough for me to take the risk in the stock market? Maybe but the point I make below brings up an important point for you to consider.
When you have debt, you have a certain amount of added risk because of every month you have to make the required payment. What if something came up (like COVID) and you lost your job? You still have to make the payment.
Whereas with investments, you could simply stop investing for the time being. Therefore, paying off debt reduces your over risk to your financial plan.
If you want more info on risk vs reward, we have a podcast that’s titled “Manage Your Risk & Your Return Will Be There” that goes into greater detail.
Step 3 – Employer Match
If your employer offers a retirement match, it’s highly suggested to at least get that. It’s free money that you won’t get anywhere else.
In addition, this is why its important to understand risk vs return.
Let’s say you’re making $80,000 a year and your employer offers a 3% match. That means if you put in $2,400 a year into your 401k, your employer will also put in $2,400 into your 401k.
That is a risk free return of 100%! You will never get that type of return anywhere else. That is why we highly recommend getting that match!
Step 4 – Paying off Debt vs. Contributing to After-Tax Accounts
We just talked about the employer match above. This section will focus more on after-tax accounts such as Roth IRAs.
Since these are after-tax and there is no match, everything we discussed in Step 2 applies here. However, there is one extra caveat.
With Roth IRAs, there are annual contribution limits. Therefore, you can’t make up lost time. Therefore we typically recommend one of two actions:
- If you are expecting income increases in the future that would make you ineligible to contribute to a ROTH IRA, max it out now while you can. We typically see this for medical doctors or a couple that is married and combined incomes will put them over the threshold.
- If you aren’t in this situation, then put a minimum towards your Roth IRA. We typically recommend $50 per month. From there, decide if you want to pay off debt or invest.
Deciding What To Do
As you see, the decision really comes down to risk vs. return. Below summarizes what we discussed above all will give you guidance on making the decision.
If the type of debt you have (Secured vs unsecured) is less risky and the interest rates on your debt are relatively low, then you will lean towards investing instead of paying off your debt.
If you have EITHER high risk debt and/or high interest rate debt, then almost 100% of the time paying off debt is better.
One big item to note, your decision doesn’t have to be all or nothing!
You may have a mix of debt with different interest rates. You can pay some off aggressively then switch to investing afterwards.
For example, we see a lot of FitBUX members with some 7% student loans and others at 3%. They have paid off the 7% loans so they only have the 3% ones remaining. Well the risk free rate is at 4% right now… Why pay off the debt when you can make more than the interest risk free!
Should I pay off debt or invest is a tough question to answer because it requires a customized solution. Plus, you have to incorporate your goals into the equation.
FitBUX is here to help you. If you have any questions, become a FitBUX member and we’d be happy to help you build a financial plan with our one-of-a-kind financial planning technology so you can achieve financial freedom as soon as possible.
By David Hughes and reviewed by Joseph Reinke, CFA