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.
Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.
Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You’ll Ever Need (2008).
Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!