Pay Off Debt or Invest?

by Jon Dulin

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Pay off Debt or InvestOn any given day, you can visit a random personal finance blog and I bet you will find this very question: should I pay off debt or invest in the market? The standard answer is if your debt is costing you more than you can earn in the market, then yes you should pay off debt. For example, let’s say you have a credit card that has an 18% interest rate. Given that 6% is a very conservative long-term return assumption for the stock market, you can see that paying off debt makes sense here. After all, why invest to earn $0.06 per dollar when you are paying $0.18 per dollar on your debt? You would be losing $0.12 per dollar!

But when we move our attention to lower interest rate debt as well as debt that can be deducted on your taxes, the story becomes a bit grayer.

I previously wrote about doing the math to determine if you should invest or pay off debt. In the end, the answer came down to:

  • Interest on debt equals more than 6%, pay off debt
  • Interest on debt equals less than 2%, invest
  • Interest on debt is 3-5%, determine what makes you most comfortable

Note you should also use a loan interest calculator to see just how much your debt is costing you.

When I say to do what makes you most comfortable, I mean pay off the debt if you would rather be debt free. If the debt doesn’t bother you, then by all means take your time paying it off and invest your money instead. Personal finance is personal – it’s about what allows you to sleep at night. I just want you to do one or the other, pay off debt or invest, as opposed to doing nothing or just spending the money instead.

Pay Off Debt or Invest: The Case for Investing

Some financial experts will simply look at the math and tell you that you should be investing instead of paying off debt because your return will be higher in the market than what you are paying in interest charges. If you are paying 4% interest on debt, and can earn 6% in the market, then you should invest. You will be making 2% more per year by investing.

While this is great in theory, it is simply that, in theory. You see, the average investor never actually earns what the market earns. The market may historically earn 8% per year, so that is the number used to justify what to do. But the average investor earns roughly 2% per year. That is nowhere near the 8% historical return. Why is this? Because most investors give in to short-term volatility. They listen to the noise that the media feeds them and are constantly buying and selling. This is the absolute wrong thing to do.

You should be staying invested in the market for the long-term, during both the ups and downs. I can’t tell you where the market is going to go tomorrow. Neither can you nor the “expert” on TV. It’s a guess. They will give you all sorts of facts to back up their conclusion, but at the end of the day, they have a 50/50 shot at being right.

I can tell you that over the long-term, the stock market will rise. Yes there are bumps along the way, but that is to be expected. I can pick out random one or two year periods where the market dropped and was negative, but looking at the trend of the market, it is positive.

Final Thoughts

If you are a disciplined investor that stays invested for the long-term, then investing in the market over paying off debt makes sense for you assuming the interest rate on your debt is low enough for this to make sense. But if the debt keeps you up at night, pay it off.

If on the other hand, you give in to the flow of the market and are buying and selling trying to chase returns, then you are better off paying off debt regardless because you are not going to have long-term success investing. Yes you might earn a great return for a year, but over time, trying to time the market is a loser’s game.

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{ 4 comments… read them below or add one }

John S @ Frugal Rules December 17, 2012 at 11:24 am

I really think it depends on your personal situation. Generally I’d say to pay off the debt, but that does not make much sense if the debt you’re talking about is something like a typical mortgage. We choose to invest as opposed to knock down the mortgage.
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Emily @ evolvingPF December 17, 2012 at 1:30 pm

If you are investing in taxable accounts you need to take the tax hit when you sell into account too since it will reduce your overall return.

Great post! I agree with your basic point, although we haven’t had too many opportunities to practice it as we only have 1 type of debt at the moment.
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Jeremy @ Structrued Settlement Quotes December 20, 2012 at 7:26 pm

I think it mostly comes down to the interest rate you are paying on the debt. If it’s credit card debt, you almost always benefit more by paying that off first. It gets trickier when the interest rate on your debt is less than 10%. Then you really need to analyze the current market conditions and how concerned you are about your debt. You might be more motivated to just keep working at paying off the debt to get some emotional relief.

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Zahra January 22, 2013 at 3:05 am

Just like what you mentioned, if the interest on debt is much lower than the interest that you will be getting from your investments, then it will be better to invest the money. Otherwise, it’s better to payoff the debt first and once debt-free, you can start investing money.
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