Should I pay down debt or invest?

If you happened to win the Mega Millions, then the answer would be pretty easy. The first thing people typically want to do is to pay off all debt. Then in no particular order, they spend, donate, and invest.

But of course, we are not Mega Millions lottery winners. Money is a limited resource, and whenever you have a limited resource, making decisions requires that you prioritize.

BEFORE GETTING STARTED…

Before asking yourself whether you want to invest or pay down debt, don’t forget the importance of having an emergency fund, which is typically 3-6 months worth of living expenses. Without building a financial cushion (even if it’s just 1-2 months of expenses to start with), you will NOT be able to go full speed ahead with either paying off debt OR investing. You can read more about emergency funds here.

You also want to make sure you have proper insurance (such as home, auto, life, disability, and liability insurance) to cover catastrophic events.

OK, now let’s look at the invest versus debt repayment question by first looking at how you would prioritize these goals separately.

PAYING OFF DEBT

The concept of paying down debt is simple. You have a beginning balance with the goal of reaching zero as your end balance. How quickly you pay your debt down depends on the interest rate and your monthly payments. Once the debt is paid off, it’s gone forever. Easy-peasy, right?

Step 1: High interest debt:

Historically, the average rate of return for the stock market has been around 7%, which is an inflation adjusted number. Therefore, 7% can be used as benchmark when answering your debt payoff versus investing question.

For high interest debt (>7%), it makes more sense to focus on paying down your debt rather than investing. The higher the interest rate on your debt, the less likely you will achieve a rate of return that will justify investing versus paying down debt.

The typical credit card APR (annual percentage rate) is typically MUCH higher than 7%, which is why credit card debt is considered a “financial emergency.” It is so difficult to start saving and investing when you have debt that is rapidly increasing and compounding over time due to a high APR.

The more quickly you can get rid of debt in this category, the better.

Step 2: Moderate interest debt:

Moderate interest debt (4-7%) is not considered a financial emergency, so you won’t need to be as aggressive about paying off debt in this category. You will, of course, want to continue making timely payments in order to pay down your debt and maintain or improve your credit score. Whether you choose to pay down this debt or invest will depend on your risk tolerance level and your feelings towards debt.

The math says that you will come out ahead by investing. But for many people, the potential opportunity cost of paying down debt instead of investing is well worth the piece of mind of having zero debt.  So you really can’t go wrong either way when you’re you’re making the decision to invest or pay down debt with moderate interest rates.

Step 3: Low interest debt:

For low interest debt (<4%), mathematically speaking, it makes more sense to invest rather than aggressively pay down the debt.

Hopefully your long term investing strategy is holding up and you’re making a better return on your investments compared to the interest rates on your debt. This means that your long term investing strategy does NOT rely on stock picking, market timing, and speculation.

WHAT ABOUT STUDENT LOAN DEBT?

Due to the current forgiveness options, student loan debt has its own special category. Your repayment strategy will determine how you will prioritize this debt.

Repayment strategy: Non-forgiveness plan (Standard Repayment Plan, Extended Repayment Plan, Refinanced loans)

You are not looking to have your loans forgiven, so your student loans are more like traditional debt and follow the steps outlined above. Remember that you may qualify for a student loan interest tax deduction, which may encourage you to put this lower on the debt payoff priority list.

Repayment strategy: Forgiveness plan (Income Driven Repayment Plans, PSLF)

If you’ve committed to a forgiveness plan, then it makes no sense to pay any extra in addition to your calculated monthly payments. Be prepared to pay your minimum payments for the entire term of the loan and save some extra if you’re expected to pay a “tax bomb” at the end of your term.  This strategy means that you can consider this a low-interest debt. You can read more about forgiveness here.

WHAT ABOUT YOUR MORTGAGE?

Mortgages are still considered “good debt” due to the following:

  • Relatively low interest rates
  • Historical gains in home value over a long time horizon
  • Ability to build equity in the property
  • Tax deductibility

Due to these reasons, mortgages are usually treated as low interest debt, so there shouldn’t be any rush to pay off your mortgage. That being said, the idea of paying off your mortgage early and being completely debt-free sounds great! This should only be a goal if you have no other debt and you’re fully maxing out all investment accounts that are available to you.

INVESTING

Investing, unlike paying off debt, is a fuzzier topic. We only have the luxury of looking at past performance, but as we all know, “past performance is not indicative of future returns.”

We simply do not know what the rate of returns will look like in the future, and even the brightest minds in the world of finance and investing cannot 100% predict what the future will hold.

However, you are pretty much guaranteed to lose money by keeping it under your mattress due to inflation, so you might as well learn how to become a confident investor and have your money start working to build wealth. Investing in the stock market is still the easiest and most reliable way that people grow their money for the long term.

Here is a common way to prioritize investing:

Step 1: Get the match

If you have a workplace retirement account that offers matching, then contribute up to the match as a bare minimum! This is considered “free money” since the only thing you did to “earn” the money is by contributing to your workplace retirement account. Where else can you double your money so easily?

Every employer retirement plan is different, so you will need to contact HR, confirm whether or not they offer matching, and make sure that you’re filling out all the proper paperwork to make this happen.

On the tax front, you will reduce your taxable income by the amount that you contributed to your workplace retirement account (provided that it’s not an after-tax account, like a Roth 401k). In addition, the money that your company contributes as a part of the match will grow tax-deferred. It is truly a win-win situation for everyone.

Step 2: Contribute to an HSA if you have an HDHP plan

If it makes sense for you to be in a high deductible health plan (HDHP), then you have access to the health savings account (HSA). The HSA is a powerful triple tax advantaged account. Your contributions are tax deductible, your earnings grow tax-deferred, and you can withdraw the money tax-free as long as it’s used for qualified medical expenses. It is truly a unique opportunity to pay for your medical expenses in a very tax efficient manner.

Step 3: Max out your IRA

The IRA is an individual retirement account, so this is separate from your employer’s workplace retirement account. This diversifies your retirement savings, and it also provide different tax benefits depending on which type of IRA you have (traditional versus Roth). You can read more about IRA’s here.

Step 4: Finish maxing out employer plan

Once you have filled up your IRA space, it’s now time to go back to your employer account if you’ve only contributed up to your match. Now you can max out your retirement account and take full advantage of reducing your taxable income and having more money in a tax-deferred account.

Step 5: If you have children, contribute to a 529

The 529 is the most popular way to save for college. The contributions are made after tax, the earnings grow tax-deferred, and the withdrawals are tax-free as long as you use the money for qualified educational expenses. You can start this account even before your baby is born, which will allow you to take advantage of a long time horizon while saving for college. Read more about saving for college here.

Step 6: Invest in a brokerage account

If you’re a veterinary professional, you should really have a brokerage (taxable) account at a major investment firm, such as Vanguard, Charles Schwab, or Fidelity. This is where you go when you need another place to invest for the long term. If you’re barely able to max out your tax-advantaged accounts, then you may not have enough money for a comfortable retirement. I want you to rock your retirement, so make sure you’re getting to a point where you’re opening a brokerage account!

PUTTING IT ALL TOGETHER: THE 9 STEPS

This is where the real fun starts. It’s also where everyone gets confused and wonders which order is the right order.

First things first: there is no one size fits all solution. This entire exercise highlights the fact that personal finance is personal. Use the following as a guideline, then do your research and see what makes sense for your personal situation.

Step 1 : Get the match

Step 2: Pay off high interest debt

Step 3: Contribute to HSA (if you have an HDHP plan)

Step 4: Max out IRA

Step 5: Finish maxing out employer plan

Step 6: Pay off moderate interest debt

Step 7: Contribute to a 529 if you have children

Step 8: Invest in a brokerage account

Step 9: Pay off low interest debt

REORDERING THE PRIORITY LIST

Maybe your employer doesn’t offer a match. Or maybe you are incredibly debt averse and would much rather focus on paying off debt before you want to focus on investing. One could easily swap out steps 6 and 8 depending on whether they would rather pay off debt or invest.

First, do your math and run your numbers so that you can start with objective data. Now, figure out whether the “math” answer to your problem lines up with your values and your risk tolerance level.

Next, understand that this doesn’t have to be an either/or issue. You can (and should) invest AND pay off debt at the same time. You are the one in charge of allocating how much you want to go towards paying off debt versus investing, so feel free to put more in one category versus the other.

CONCLUSION

Hopefully this post has provided some clarity when it comes to debt repayment versus investing.

The important part is to make sure that you stay focused and stick with your plan. Executing your plan will be MUCH easier to accomplish if your decision is based on not just the math, but also according to your values and preferences. The money that is earmarked for paying off debt or investing must go into one of these two categories. Once you start using this money for anything other than investing or paying off debt, then you’ve lost your momentum on both fronts. Stay the course, and you’ll be well on your way to achieving your financial goals.

How would you order this list of priorities? Do you prefer focusing on investing or debt payoff? Comment below!

2 Comments

  1. The Vetducator on May 15, 2019 at 2:35 pm

    We flipped 8 & 9. There’s something to be said for a guaranteed return on investment (paying off the houses) vs. a potential return on investment (stock market). Statistically, mathematically more likely to earn more in the market, but you never know…

    • RLDVM on May 16, 2019 at 6:04 am

      Congrats on a paid off home! That must feel amazing!

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