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Should You Pay Off Your Debt Before Investing?

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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.

  • First, if you have any credit card debt you should not be investing. Pay that off first as the cost almost certainly exceeds any reasonable expectation of return on prudent investments. So pay off all of your credit card debt every month before you invest.
  • Second, if you have any fixed income investments (e.g., bonds, CDs), you should likely sell them and pay off your debt as the return on those investments is likely to be less than the cost of the debt (unless you have a subsidized student loan).
  • Lastly, I would also pay off any debt before investing in stocks and the reason is that you will not be receiving the full risk premium for taking the risk of owning equities. So you are taking stock risk but not getting stock returns (net of the cost of the debt).

Risk Premium: Why You Should Pay Off Debt Before Investing

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.

  • So longer term Treasury bonds have provided a risk premium of about 2% a year above the return on one-month T-bills. That is a premium for taking what is called term risk (related mostly to inflation).
  • Stocks have earned about 7% a year above the return on T-bills.
  • And riskier small and value stocks have earned further risk premiums.

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).

Investing in Tax-Advantage Accounts

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.

  • Keep in mind that many people with mortgages actually don’t get the mortgage deduction because they use the standard deduction and others don’t get it because of the AMT.
  • You should also consider that paying off the debt is a riskless transaction, while unless your fixed income investments are backed by the full faith and credit of the U.S. government, there is some incremental credit risk that should be accounted for.

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.

Mortgage is a Debt Just Like Any Other

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.

Paying Down Your Mortgage Versus Investing

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.

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Mr. ToughMoneyLove
11 years ago

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.

Larry Swedroe
Larry Swedroe
11 years ago

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… Read more »

The Weakonomist
The Weakonomist
11 years ago

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.

Miranda
11 years ago

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.

Pinyo Bhulipongsanon
11 years ago

@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.

Sweeney
Sweeney
11 years ago

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!

Bob
11 years ago

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…

Pinyo Bhulipongsanon
11 years ago

@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.

BobV
11 years ago

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.

Pinyo Bhulipongsanon
11 years ago

@BobV – That sounds wonderful. Congratulation. 🙂

Lalos
Lalos
10 years ago

I believe everyone needs a cushion fund, an amount of money for emergencies. Above that, pay off the debt, absolutely.

Should You Pay Off Your Debt Before Investing?

by Larry Swedroe time to read: 4 min
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