The question of whether or not to invest or pay of debt can always lead to heated discussion with good arguments for both. At the end of the day, it’s really going to come down to how comfortable you are with debt.
Some people don’t care, others are so debt-averse they’ll pay down even the smallest balance at 0% interest as fast as they possibly can. I’m of the general camp that you shouldn’t be lugging around debt just for fun.
If you can pay it off, pay it off. If you can’t pay it off, find a way to start paying it off. Seriously, pay your debt.
Nevertheless, there is a myriad of strategies out there. So if you’re getting defensive about making minimum payments on your student loans while you build a dividend investment portfolio, just chill.
Should you invest or pay off debt?
The following assume you’ve already got your financial bases covered. For example, you’re not behind or have defaulted on any of your debts, and you already have an emergency fund of at least $2,000 (but preferably more).
The question of whether or not to invest or pay off debt should come only after you’ve got the rest of your financial house in order, and you’re looking for the best way to maximize your dollar allocation.
If you’re struggling to meet your bills or have nothing saved in case disaster strikes, you have more pressing things to worry about than where you’ll get the best return on your money. However, if you’ve got everything together, read on.
Is the interest rate on your debt higher than the return you expect to earn on your money?
As a general rule of thumb, you should be earning 2 to 3 times more in the market than your paying on your debt. This means if your debt is at an interest rate of 3%, you should be getting a return of at least 6%.
Why 6%? Because if the difference between your debt and rate of return in the market is only 1-2%, the weight and risk of carrying debt far outweigh the benefits of your rate of return in the market.
Some of the risks of choosing to invest instead of paying off debt are:
- Companies can cut their dividends. You can go from getting a 5%+ yield on a stock to 2% in a single announcement. Additionally, a dividend cut typically negatively impacts the stock price, reducing the capital you can retrieve from the investment.
- The market does not provide a guaranteed return. Historically, stock market averages are fairly juicy, but the average is just that: an average, which means it’s mixed with some up and down years.
- Your creditor can increase the interest rate on your debt. If you owe an organization money, they’re in charge, not you. This means they can up your interest rate at any time, and all they need to do is send you a letter to let you know they’ve done so. Many students are lured into large debts with super low interest rates, like 0% to 3%, when they’re in school, only to see that number jump to 5% or more after graduation.
For this reason, it’s often better to opt for aggressively killing your debt before you focus on investing.
Is your debt balance above $20,000?
This is an arbitrary number, but it’s a good benchmark. The higher your debt owing, the more interest it accumulates — even at a low interest rate.
If you owe $25,000, your interest rate is 3%, and your monthly payment is $150, over 40% of your monthly payment is going towards interest and not touching your principle. At the end of the first year you would have made $1,800 in payments towards your debt, but only reduced the balance by just over $1,000.
That’s $800 that’s disappeared to interest and is more or less the cost of carrying the loan. Is it worth lugging the debt around around for $800?
The bigger your balance or the higher your interest rate, the faster it works against your monthly payment. Even if you’re eager to get started in the stock market, make an effort to knock your debt balance down to something that won’t choke your efforts. Annihilate a good portion of your debt, then begin splitting your efforts between paying down the balance and saving on the side.
Do you want to make a significant purchase, such as a home, in the near future?
Many people often forget that debt can be a drag on their future plans. We are so comfortable with balances owing, that we shrug and lug around student loans, lines of credit, and so on for years… until they get in the way of something we want.
When it comes time to buy a home, how much house you can afford is not just about the down-payment, your affordability will be assessed by the monthly mortgage payments you can make. If you have recurring loan payments, this is money that can not go towards house payments, and therefore is deducted from your affordability.
So it’s up to you: do you want to spend $300 per month on credit cards or a car, or do you want it to go towards building equity in your dream home?
Did you purchase stupid things with your money?
This point is purely about the emotional cost of debt. Fundamentally it doesn’t actually matter if the $100 you owe on your student loans bought you a textbook for calculus class or five extra-large pizzas, it’s still $100 owing.
But there’s something less frustrating about paying interest on the money you borrowed to feed your mind, than money borrowed to feed your fun.
If you want to pay 3% or 5% or whatever interest for 5 years on the beer you drank in college, that’s fine — but personally I balk at places that charge $8 for a pint, so I can’t imagine the final cost coming to $10 or $15 after interest however many years down the road.
Go back through your old credit card statements or tuition bills, and figure out where your money went. Pay off the bad purchases as fast as you can, even just for pure peace of mind. Even if your interest rate is low, you’re getting a good return in the market, your debt is tiny, and you have no need for a mortgage in the future, I’m going to shake my head at you if you’re carrying the cost of Starbucks lattes around.
You can always adjust your debt repayment and investment strategy as you go.
I took a blended approach when I paid down my debt, opting to save and invest on the side. At first, this made me feel financially secure like I was covering all my bases.
But as the months passed, I became frustrated with my debt and eventually cashed out a lot of my savings vehicles to wipe out the remaining balance.
In other words, what you do right now isn’t what you have to do forever.
If you try a debt and/or investment strategy that doesn’t work for you or doesn’t feel right, you can change it later, the most important thing is that you continuously work towards maximizing your net worth.
My husband and I are currently 154K in debt. We invest enough to get our employer matches through our 401Ks, are saving a 1-2 months of income emergency fund (currently at 3K), and then pay everything else towards debt.
When a loan balance gets low, we will wipe out savings down to the 2-3K level to knock the loan out. But, having the larger e-fund the mean time (though we pay more in interest) reduces risk. Plus it feels really great to be able to knock out those loans when they get smaller as well. This month we paid off an 8K loan in one fell swoop that way.
That’s great that you’re getting those employer matches & working on the EF!
I totally get the good feeling of wiping out a few thousand dollars with savings right at the end… it’s like the final sprint over the finish line. $8K in one go is crazy! Great job! $154K is a lot of debt, but looks like you’re serious about it so I expect it will be gone in no time 😉
While I would like to invest some of my money every month, my main focus for the last few months was paying down my debt. I have been using the snowball effect and I’m very happy with my progress. I am currently working on my second largest balance that has 3% interest and hopefully it will be paid off by the end of April. My largest loan balance is about $15K and doesn’t have interest, so I was thinking about investing while paying off the balance. However, the thought of being completely debt-free makes me want to put off investing a little longer. Not really sure what to do.
That’s fantastic! $15K isn’t bad at all if it’s your biggest balance. If it’s 0%, you can afford to make different choices of where your money goes for sure… but there is still an emotional weight of debt. My fiance never borrowed money from banks or student loans to go to school, but he did borrow from his parents. They didn’t charge him interest, but he was serious about paying off the debt quickly just because the emotional weight was heavy — he didn’t want to take any money away from their retirement, so if they could be earning interest/dividends on what he took out for school, he wanted to give that back to them as quickly as possible.
There is a lot to be said about being free of any creditors. It’s worth something, even if there’s no math to it. Knowing all your money is your own is an incredible feeling — otherwise with a $15K debt, you know $15K of your savings isn’t truly yours, even if it’s earning you a small return.
This is always a hard issue for me. As a lawyer, I started working later in age that most of my friends and felt the need to start saving for retirement right away. I also have a huge amount of school loans (about the same as the average house cost where I live). I don’t intend to buy a home or a new car in the next 10 years or so and otherwise keep my costs low. I make payments towards both, but its not the huge amount. Its always a mental battle for me because I never feel like I am making enough progress on either side of retirement or debt.
This is a great article. I like to try and invest and pay off debt at the same time. So long as my loan payments are debited from my account each week or month, and the balance is reducing, I’m fine with it. I have around 9k left to pay off in student loans, and I have 3k in savings for an emergency. I have no retirement savings yet and I turn 25 in December so I’m worried about that.
My flat mate buys stupid shit all the time lol. He is a student and has student and car loans, and he’s just bought a dog on his credit card! Can you beloved that? He spent 2k on a French bull dog puppy, and were only renting.. And when I scold him for adding impulse buys to our grocery shopping, he tells me it’s ok because he has money – his CC.
The market does not provide a guaranteed return – This is a huge point!!! With interest on debt, people “know” at least as it is a concrete number (you know you will pay x% but, you do not know what x% market return you will receive). Do people use the market to offset their debt?
The fact that the creditor is in the driving seat and can increase the interest rate on your debt is unsettling as well.
It should come as no secret that I prefer paying off debt. Even though it probably makes more sense for me to invest, I prefer the stress relief of reaching debt freedom.
I definitely used a blended approach as I was paying off my slightly more than $28,000 of student debt.
I still paid it off aggressively – it took slightly less than two years to do it – but I started saving along the way.
My No. 1 reason for starting to save while paying off debt was because I’m a freelance journalist so I wanted to have the security of a growing emergency fund. If I didn’t have any work one month, I didn’t want to end up in a situation where I had no money.
My No. 2 reason for starting to save then was to get in the habit of automatic savings before I became debt free. I started out really small, putting I think something like $50 biweekly into an RRSP and $25 biweekly into a TFSA. It helped make a natural transition into aggressive saving after paying off my debt because the channels were already set up and I was already in the habit of doing it.
Another important consideration is “how close to the bone are you?”. If your debt payments cause you to only be in the black by a couple hundred dollars each month, then you’re over exposed to even a small bump in the road. At a time like this you need to be paying off some of the smaller loans and getting a little breathing room before you invest.
What’s your opinion on paying down debt versus saving/investing? We have no other debt except for $200k remaining on mortgage with 15year amortization at 2.05%. We currently contribute to pension and RRSP but are not maxed out on either of RRSP. Your thoughts?
RRSP! Your interest is so low on your mortgage you’re probably going to get 2-3x the return by investing through your RRSP. Also I’m always a big fan over cash assets than a house! $200K in stocks is more powerful than $200K in residential real estate.
Thanks. Greatly appreciate the insight from someone with a good knowledge base !!! Even though I wouod love to reach the point where my mortgage is paid off sooner, I understand exactly what you are saying!
I’ve read a couple of your blog articles now and I really like the fact that you seem genuine in helping people with their personal finances. As a mortgage broker, I have come to realize that people really need a lot of help, whether they agree or not.
I am having some troubles however, with some of your calculations and on the topic of financial decisions, the math is key. The interest costs and payment amount in the example of the $25,000 loan didn’t look totally right to me until I figured out that you were using an 18 year amortization which could really only be accomplished with a mortgage.
Were you referring to a mortgage refinance? If so, this would imply a much different scenario and it would require some other calculations.
I’m not trying to be a thorn in your side. I just think that someone who is trying to help people make smart financial decisions should be very careful in providing accurate calculations that speak to real world situations.
I also found one of your comments a little contradictory. For example, your blog seems to paint a picture of being cautious of borrowing to invest and you mention personal actions of pulling funds from investments to pay down debt yet, in a reply to a reader comment, you quickly recommend contributing to an RRSP over paying down their mortgage.
Hi Jim, you are right on many points here wiohutt more information about how they will be structured it is really hard to assess the value of PRPPs. I think the major issue is whether the program is mandatory for employees or not! The reason why pensions work is because it is a force savings. People have to pay CPP and they don’t even realize the money is gone. Without the PRPP being mandatory there is nothing more here than a group RRSP plan and this will only be one more thing for people to get confused and frustrated over. I guess the only way to avoid that would be to have mandatory education to go with the non-mandatory program. Like I said we need more details!