If you have extra cash or come into a sudden windfall, is it smarter to pay off your debts or invest the money?
A woman came into my office the other day wondering this exact thing. Well, she didn’t ask the actual question… I did.
She had a mound of credit card debt, clicking away at 12% interest. What surprised me, though, was that she already had the $50,000 needed to clear out the credit card debt. Interestingly enough, she didn’t plan on using any of it to pay off the card! She wanted to invest the money instead. She estimated that she could earn much more than the 12% she was paying on the credit card, so she concluded that paying it off was a silly thing to do. Her money was best served elsewhere.
It turns out that this woman was in debt all over town, even though she had substantial assets. Never mind that her credit score was in the dumpster, she wanted to invest. I had to convince her to reconsider.
Could She Have Been Right?
To you and me, the answer in the above woman’s case might be a no-brainer. But other situations aren’t so clear-cut. In order to really address this issue, you have to understand all the components of the question.
First, there’s the basic financial question, which is rather simple. Ask yourself which number is greater, the return on your investment or the interest you are paying. If you’re paying more interest than you could earn, pay down that debt!
For example: assume you owe $10,000 on a credit card. Let’s say that you actually have the $10,000 in the bank, which you could use today to get out of debt completely. The credit card interest rate is 10%, and the bank is paying you 1%. At first, this seems like a slam dunk. Pay off the credit card. Right? Not so fast…
Assume that you also have an opportunity to invest $10,000 in your brother’s “can’t lose” vending machine business. He tells you investments are earning 30%, which is quite a bit more than the 10% you’d save paying off the credit card. Now the choice becomes more complicated.
If you pay off the credit card, you’ll make a guaranteed 10% return. Why? Because that’s money that you’ll keep in your pocket rather than sending it off to Visa or Mastercard.
If you invest in the vending machine business, you’re guaranteed nothing. You might earn 30%… or even more! But you could also lose everything. It’s happened once or twice in the past when people invest in small businesses.
So, which is greater? A guaranteed 10% or a possible 30%? The only way to approach this is to estimate the likelihood of earning that 30% on your investment. If the chances are high, you might go for it. If not, you might pass.
But there are other scenarios. What if the cost of that credit card debt was only 5%, and your alternative to paying it off is to invest in some mutual funds? What if your timeframe was 5 years for those mutual funds? Assume you estimate that the average return of the funds over that period of time will be at least 8%. Now, which do you choose?
While you still have to do the above calculation of estimating the likelihood of achieving those results, you have the added element of time to consider. What is the expected return of the alternatives over the given time horizon?
This is also especially true with mortgages. If you come into a sudden windfall, you could theoretically pay off your home loan early, clearing up a very large debt. But is that (likely) 3-5% interest rate really your best option, given that you could invest that cash and earn a 7-8%+ return? You need to ask yourself some big questions.
What Other Value Does That Money Hold?
So, from a financial standpoint, you must consider all the alternatives: the cost of the debt, the likelihood of potential alternatives coming about, and the downside risks over a given time frame. It’s a lot to consider.
Beyond these financial considerations, though, there are also the emotional points. How would you feel if you paid off the debt? How would you feel if you don’t invest? How would you feel if the investment doesn’t work out?
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I have found that these emotional questions are just as important as the financial questions. What good is it to make an otherwise smart financial decision if, at the end of the day, you are left feeling miserable?
In most cases, you can simply ask yourself a few questions and come up with a really solid decision. This should allow you to address both the financial and the emotional issues:
1. What happens if you pay off the debt and the other investment does well?
Your answer will be unique depending on the situation. If the investment turns out great, how might it change your life? Are you giving up your chance of a lifetime? Or are the upsides of the investment actually very limited? What are you giving up in order to pay off the debt? Does it make sense to make that decision?
2. What happens if you pay off the debt and the other investment does poorly?
If this happens, you’ll probably feel like a genius. No problem here. (My apologies to your brother on his vending machines, though.)
3. What happens if you don’t pay off the debt, make the investment, and it turns out well?
What is a reasonable expectation for a “good” outcome, and what does that look like? Can your money double? Triple? Or is the upside, even in the best case, so limited that it just isn’t worth it? What is a reasonable expectation?
4. What happens if you hold the debt, make the investment and it turns out badly?
Can you afford to lose the money and be stuck with the debt?
A man I know borrowed money to invest in the stock market. Not only that, but he invested very aggressively and lost 30% in 3 months. At the end of the day, he was $150,000 underwater and needed to pay 10% to his lender. This bad decision forced him to sell his business and declare bankruptcy. Clearly, he never thought about the downside before choosing the investment over staying out of debt. He was an optimist who never considered the risk.
Read More: Rebuilding Your Credit After Bankruptcy
I have found that by asking myself these four big questions (and really thinking about the answers), I make better financial decisions between two competing alternatives.The answer isn’t always as cut and dry as it was for the woman in the beginning example, but that doesn’t mean you can’t still figure out the best, smartest option for your money.
So, how do YOU decide between paying down debt or investing?
17 Responses to “Extra Cash? How to Decide Whether to Pay Off Debt or Invest”
One or two other points to ponder on this subject:
(1) Tax laws for individuals are changing rapidly and the federal government has another surprise for those taxpayers who wind up paying the Alternative Minimum Tax (AMT)—Mortgage interest is one of the items \\\”added back\\\” in the AMT calculation (tax calculated at 26%-28% and more commonly assessed because there will likely be no \\\”patches\\\” on the ATM in the coming years whereby millions of more American taxpayers will be obligated for the AMT.
(2) By not paying mortgage interest, you are saving real money, dollar-for-dollar. On the other hand, if you get earnings on your money, in the future there will be ever-higher capital gains rates as well as also considerably higher rates on \\\”ordinary income.\\\” This is one of the primary reasons why so few major industries will even consider building a company in the USA and create jobs for Americans…both over-taxation and over-the-top involvement in your business by the various levels of government and/or tax authorities (city, county, regional, state and federal).
(3) Home ownership is not the ideal anymore. It limits your ability to move for employment or quality of life purposes (home values are still dropping, resale is growing harder, and property taxes will have to increase considerably as ever more localities need more money to operate (even on austerity budgets). At least if you eliminate your debt, you can rent out or lease the property, and even move back in later…it is best to have as many choices as possible. That can only occur these days by becoming just as debt-free as possible as quickly as possible…period.
Thomas Avery Blair, EA
Its better to invest in your own home than in wall street. The stock market or the S&P 500 return rate was -37.22 percent in 2008 which will take many years to recover from.
By paying off your mortgage you get a guaranteed return rate of close to 6% percent. 6 percent beats any 5 year CDs or 30 year gov bonds after 20 percent capital gains or dividend taxes.
Great article! In the economist world, it seems all the rage to do studies on the “irrational” aspects of how people make monetary decisions. Often trying to tie it to evolution or something, but I think there is a simpler answer, which is addressed in this article, we are creatures of not only logic and reason but also emotions. What good is it if do the ‘perfectly logical’ thing but end up loosing sleep over it? I think those four hypothetical questions do give some introspection.
Pay off debt or invest? that is a good question. The safest option is definitely pay of debt. An investment is always a risk. Suppose you invest and you find out it was a bad investment and you lose all your money :O
So my choice would be pay off debt.
Just going by the numbers you would usually pay off the debt, since these days most interest paid on debt will be higher than interest rate earned. However, if paying off debt is an endless battle (and often even if it is not) then saving some small amount while you pay off debt will give you some emergency or spending money, so you don’t keep building up debt. Just going by the number this may not make sense, but it does teach you how to save, so it is not a bad lesson to learn.
This is such a hard question to answer. Sometimes you can do really well with investing; so well that your interest can pay off your debts. However this can take time and the longer you take to pay off your debt the more stress and interest you experience.
This is something I have been thinking about these past few months! I have a credit card debt of just over $16k and could easily pay that off, but instead I have been saving money for a down payment on a house. I know the market is stabilizing where I live and interest rates are extremely low. I guess you have to look at the whole picture. Assuming that this house I am buying will stay at or around the current value and with the mortgage rate of 4.4%, it seems like a wise decision to buy the house and pay off the credit card debt at a later time.
If things went down the tubs for me with my income, I could always just rent out the house. It is an investment ‘risk’ but I believe buying a house is a safer bet, especially since people will be renting for years to come.
One of the best articles I’ve seen on the subject. Good job Neal!
This article reminds me of something Dave Ramsey is known to say:
“Assume you don’t have any debt. Would you take on new debt to purchase the ‘investment’?”
If the answer is no, then sell the investment and pay off the debt…
Taxes matter not just on the investment side but the debt side. My mortgage and student loan interest is tax deductible at my marginal rate. To me it’s preferable to invest in tax deferred accounts and carry balances on those loans, which have an after tax interest cost of approximately 3%.
Consumer debt is a different story. I would venture to say that if you’re in credit card debt, you’re not in a position to “invest” (I would say “gamble”) on a family member’s business venture. Almost no one is able to generate consistent investment returns in excess of typical credit card interest.
I wonder if one might throw another curve at this question? If the individual learned that his or her home was in jeopardy and that almost all of today\\\’s mortgage notes do not require repayment of the mortgage obligation in dollars but rather in \\\”current US legal tender.\\\” Put in simple terms…Imagine those credit cards fall delinquent, your credit score drops, you find yourself either sued for your debts and/or those debts are forgiven (Form 1099-C Calcelation of Debt) that in turn produce 100% taxable income…plus you lose your job and cannot make your house payment anymore either because you lack the means from your wealth and/or because the \\\”fiat\\\” greenback US dollar becomes all but worthless and ceases to be considered \\\”current US legal tender?\\\”
For the most part, I tell many of my own tax clients to seriously consider an immediate pay off their mortgages (assuming they are not \\\”under water\\\”), live thereafter well below their means and trust no one with their wealth except themselves…and build their wealth via education and job skills, personally-possessed gold and silver, and raw arable land for best long-term results as this recession takes ever-stronger-hold onto the dollar-denominated wealth of the USA and its citizens.
Debt can be a servant, but these days it is by far more likely to be an unforgiving master.
At least food for thought, is it not?
Thomas Avery Blair, EA
Does it have to be all or nothing?
What if she paid off half and invested half?
If she is set on investing money you could convince her that splitting the money between investments and paying off debt she could “double” her return the emotional aspect might appeal to her.
… not the slightest mention of “inflation” in the considerations (??)
It’s a huge factor in any investment or credit decision.
Inflation helps people who owe money… because they pay back the debt with $$ worth less than the $$ originally borrowed. OTOH savers & investors get hurt by holding assets with depreciating value.
U.S. government debt is staggering and the Federal Reserve prints money wildly. 15-20% annual inflation rates (like the 1970’s) are more than likely coming… and probably worse.
Inflation factors can not be ignored in present/future value calculations.
@Selling Theta, you are correct. Taxes are an important element in any financial decision. I never make investments solely based on taxes but I do consider the tax fallout when I decide the timing of when to invest sometimes.
@Tara You are right. I should have used the word \\\”risk\\\” more in the post. I talk about risk all over the place but I don\\\’t really hit it with a huge spot light. Thanks. That\\\’s really good feedback.
I like this post. I’ve argued about this concept on occasion with people I know. While risk is implied in this post I don’t really see it addressed as a significant and real factor in making this decision. Shouldn’t that be considered as well? Risk measurement does have significant financial implications that are often ill considered. The “downside” of the example you site in the fellow who borrowed to invest would be called Risk and from that example it is clearly significant. (Can you tell I’m a Dave Ramsey listener. Risk gets drilled a lot!).
Good analysis. One thing though, you should incorporate the impact of taxes and how that will affect the optimal outcome. The interest you pay on personal debt is not tax deductible, the returns you make on investments are. This will slightly impact whether or not you should pay down existing debt or not…
Taxes also play a big role here. You have to pay down your debt with after tax money and your investment returns will be taxed as well at 15% or at your marginal rate depending on what kind of income it is. When your return is taxed as self employment income as a vending machine business might, the near 50% you might pay in taxes on that income (self employment, federal and state) will very rapidly convince you to pay off the debt.
The emotional factor was big in our decision to pay off our mortgage. Add to that interest rates on savings accounts are dismal and have been for quite a while, thanks to the FED.
A friend of mine tried to scold me for paying off our mortgage and losing out on the tax advantage. I had to set her straight. We were basically paying a dollar in interest to the bank to get 25 cents back on our taxes. It took her a moment, but it sank in that we were still on the negative cashflow side of things.
So yes, our tax bill went up. But our living expenses went down condiserably without a mortgage payment. And the peace of mind knowing we’re not in debt to anyone is worth a lot.