“Should I pay down debt or invest?”
It’s probably one of the most popular money-related questions out there.
Most of us have some form of debt (a mortgage, a car loan, etc.) and most of us either currently invest, or have high hopes of starting. But of course, there’s only so much money to go around! While it’d be nice to do both, we have to make tough choices of where to put our money.
What if I were to tell you that making the right choice can save you thousands! And while simple, the decision does require some thought to be tailored to your situation.
Want to learn more?
This post will be a 2-part comprehensive guide on how to make the best choice – whether pay down debt or invest. Today I’ll introduce you to the general rule of when you should pay down debt, and later this week (post here) I’ll walk you through a very actionable guide on how to get started.
Are you ready? Let’s go!
The General Rule
I’ve kept my approach for this very simple. Too often I find that we make money concepts complicated (and for little additional benefit!). Sure, I could be more analytical and list out several “if-then” statements, but complicated models are no use if they aren’t put into practice.
Instead, here’s a simple solution that meets 90% of everyone’s needs. Something that’s easy to apply is always much better.
Ready for it? Here’s the secret recipe: If your debt costs you more than 5% interest, pay it off first.
Plain and simple.
Why 5% you ask? That’s an excellent question. Let me start by explaining about an important concept called “risk and reward.”
Understanding the Risk and Reward trade-off
Let me start by saying that both paying down debt and investing have a positive impact on your net worth. At face value, both are very good to do. One adds some assets, while the other reduces some obligations. There is one small but VERY significant distinction though…
Paying down debt is guaranteed to increase your net worth while deciding to invest does not.
Every dollar that you put down on your mortgage is good for you. You increase your net worth dollar-for-dollar. Investing, on the other hand, is a little trickier. Every dollar you invest has the chance to earn you more money and put you further ahead. There’s no guarantee on how well your investments might do. Every $1 invested might earn you $1.60 if you make some wise decisions. But it could also only be worth $0.80. It’s never a sure thing.
That’s why the better question to ask is at what point is it worthwhile to take on more risk investing in hopes to “get ahead”?
That’s how I came to the 5% rule.
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OK, I get the idea, but why still 5%?
If your debt is costing you more than 5%, pay it down first. You’d be better off going with a sure-thing (paying down debt) than taking a risk by investing.
Your chance of making more than 5% by investing becomes increasingly difficult. On average the stock market has returned about 6-7% (adjusted for inflation) since 1871, but it can fluctuate from year-to-year.
Bad market conditions can and do happen. That’s a regular part of investing. Because of this, I don’t always rely on earning the historical market return of 7%. I give myself a buffer and only count on about 5% per year.
On the other hand, if your debt only costs you say 3%, you’d be better off having your money work for you. Why would you want to increase your net worth by 3% paying down debt when you could earn more (say 6-7%) in the stock market? You’d be leaving money on the table!
And of course, there are exceptions to every rule
My general rule may not apply to every situation. Below are a few cases where you might want to take a different approach than what’s typically recommended:
1) The idea of carrying debt makes you sick – Some people can’t handle the idea of staring at a negative number. They get anxious even thinking about having to owe someone money. In this case, I’d say work at paying down your debt to “manageable” levels first. There are enough worries in life – money shouldn’t be one of them. It’s not worth earning a few percentage points at the cost of your health.
2) You have a considerable amount of debt – If you count every penny to meet your current loan payments, you might want to consider paying down debt first. Being maxed out in debt is never a good idea. It puts you in a very risky position. What happens if you were to lose your job? Would you be able to keep up with your payments for the next 3-6 months? If not, it makes sense to trim it a bit to a more tolerable level. Like the point above, reducing overall risk is more critical here than trying to maximize your net worth.
Closing thoughts – neither option is “bad”
I’ll close this post by saying that neither paying down debt nor choosing to invest is a bad thing. In all honesty, you can’t go wrong either way. If you’re thinking through both options, you’re in the right headspace, and that’s what matters most!
What I’m talking about here is how to maximize your net worth over the long-term. Making right decisions at the margin can help over time. If you’re taking the time to think this through, I encourage you to do the same across all money-concepts. Constant refinement and small consistent wins in your finances will lead to a lot of benefits over the long-term. I also encourage you to read Part 2 of this series here!
Think it through
- How is this approach different from what you do today?
- Do you prefer this approach? Why?
- Is there anything placing you in favor of paying down debt instead of investing?
- How not to overspend and save money
- Why budgets actually give you more freedom
- Should you pay down debt or invest? Part 2 – Find how to start now!
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