Is it best to get out of debt before you start investing? This is a common question that comes up quite often. The issue is actually fairly complex considering the many different types of debt and investment options available. In general, the answer is you should pay off your debt before investing. Here are some general guidelines.
The cost of the debt you have is almost certainly higher than the risk-free rate of return (the return on one-month Treasury bills). Other investments like stocks have higher expected (but not guaranteed) returns. The higher expected return is called a risk premium. And it is called a risk premium for a reason; you are taking risk. How large a premium is a reflection of the degree of risk.
Thus, the market has historically priced stocks to provide that size and value risk premium.
Let’s take an example. Say treasury bills are at 4% and we expect stocks to return 10%. That is a risk premium of 6%. But if your debt costs you 8% then your risk premium is only 2%. You are taking risk that the market prices at 6% and earning just 2%. That does not make sense to me.
Now it is a bit more complex since you should look at after tax returns. So you should adjust the cost of the debt to reflect the true after tax cost (assuming the interest is tax deductible) and adjust the equity return to reflect the lower capital gains rates (assuming it is in taxable account).
Does this advice take into account the initial tax savings from investing in retirement accounts such as IRAs, 401k, etc.?
The answer is to do the math. You look at the after-tax return on your fixed income investments and compare it to the after-tax cost of the debt.
Typically what you will find is that the highest after tax return you can get (on risk-adjusted basis) is by paying off debt, especially credit card debt, auto related debt, etc.
Another important issue relates to mortgage debt. Many people make the mistake of not thinking of the mortgage on their home as debt when it comes to their asset allocation. Mortgage debt should be treated the same way as any other debt in terms of analyzing the costs versus the expected return on any investment.
If your financial plan requires you to earn a high rate of return then you may need to carry a home mortgage and take the risk of investing in stocks (instead of paying down the mortgage). But you then should be sure you also have the ability and willingness to take that risk as well. My book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, has a chapter on how to build a portfolio, specifically addressing the issues of ability, willingness and need to take risk. I provide specific tables that are easy to use to help you figure out the right asset allocation for you.
On the other hand, if you have a fixed rate mortgage with a long maturity still left, and the math works out to be a small advantage to paying off the debt versus investing in short to intermediate fixed income investments then you might want to hold the mortgage because it does provide inflation protection. And that is worth something.
I would add one last point. While stocks have historically earned about 10% a year, providing that large risk premium, most financial economists believe that going forward the return to stocks will be somewhat lower, more in the range of 7-8 percent per annum.
Disclaimer: Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
Nice article. Regarding the statement about a mortgage providing inflation protection, that is true if your income keeps pace with inflation. Otherwise your mortgage payment still represents the same percentage of your income, even if you are repaying with inflated dollars. For most Americans today, incomes are not growing with the rate of inflation.
1) If you have inflation then you are repaying the debt with lower cost dollars in REAL terms. That is true regardless of other issues. So for example, over the long term your home, which is a real asset would likely appreciate in value but the mortgage payment remains the same. Again an inflation hedge (of course the mortgage rate has an expected inflation rate built in).
2) If you have a fixed rate mortgage and fixed income assets and inflation rises then your mortgage stays the same but your fixed income assets will generate more income to reflect the higher inflation
3) Stocks are also real assets and over the long term their returns should reflect higher or lower inflation. So you get higher inflation and your mortgage rate stays the same but you NOMINAL equity returns (not real equity returns) are likely to rise as well. Again, assuming you have stocks as well as your mortgage.
Here’s my approach:
Save 15% all the time for retirement.
Devote all other funds to paying down debt (currently nothing for me).
Buy a house and make minimum payments.
Use money for extra payments to invest.
Once the balance of the extra payments invested equals the balance on the house, pay it off (taxes included).
It’s not the best plan but it works for me and gives me a cushion for an emergency that won’t require me to pull equity out of my home. Now I just need to buy a house.
Thanks for the great post on paying off debt before investing. It’s important to realize that what you pay in interest often exceeds your yield. I also like what Weakonomist says about saving for retirement.
@Weakonomist – For the most part I agree with you. But I don’t know if investing 15% for retirement is a good idea when you owe credit card debt.
Thank you very much for your post. I believe this is very sound advice. I am going to have to sit down with my wife over the weekend and review all of our options. Thanks again for the post!
I have been working on investing and paying down the debt at the same time – but only because I know that I am not going to “fall off the wagon”… That said, I do understand why Dave Ramsey preaches what he does about knocking it all out first – for many people they need to do it that way…
@Bob – In a way, I am doing the same. I am not waiting to pay off my mortgage before investing. But Larry’s numbers make a lot of sense.
I like the direction of the article. I was investing heavily while carrying a mortgage with a relatively high interest rate. When my wife and I decided to become totally debt free, I cashed in some of my investments, paid off the house, and have been been amazingly blessed ever since. It’s great to be debt free, retired, able to give freely. Thanks for the article.
@BobV – That sounds wonderful. Congratulation.
I believe everyone needs a cushion fund, an amount of money for emergencies. Above that, pay off the debt, absolutely.