Investors often struggle with deciding whether to pay off debt or invest, but in many cases there is no single right answer. Both choices build net worth, just in different ways. Paying down debt reduces liabilities while investing increases assets. The key is to avoid extreme decisions. Giving up an employer match to pay off debt or carrying high-interest credit card debt while hoping investments will earn more are generally poor financial moves. Outside of situations like these, either approach can be reasonable. The most important factor in building wealth is consistently directing a meaningful percentage of income toward investing or debt reduction instead of increasing consumption.
Several personal and financial factors can help determine which choice makes the most sense. Personal feelings about debt matter because behavior often outweighs math. Some investors sleep better becoming debt-free as quickly as possible, while others are comfortable carrying low-interest debt for years. Risk tolerance also plays a role. Investors who prefer conservative investments may receive a better guaranteed return by paying off higher-interest debt. Tax-advantaged accounts should also be considered. Opportunities such as employer retirement plan matches, 401(k)s, Roth IRAs, HSAs, and education savings accounts often deserve priority before paying off low-interest debt because of their significant tax benefits. Expected investment returns, current market conditions, and the interest rate on the debt should also factor into the decision, recognizing that higher-interest debt becomes increasingly difficult to outperform after adjusting for risk.
The decision becomes even more nuanced as wealth grows. Investors with substantial assets may have less need to leverage low-interest debt in pursuit of higher returns, while those early in their careers may reasonably choose to invest more aggressively as they build wealth. Asset protection and estate planning can also influence the decision. State homestead laws, creditor protections, and tax considerations such as receiving a step-up in basis may make carrying debt advantageous in certain situations. Rather than searching for a universal rule, investors should create a financial priority list that starts with employer matches and high-interest debt, followed by maximizing tax-advantaged accounts, investing in assets with strong expected returns, and then addressing lower-interest debt. The specific order will vary, but long-term success depends far more on consistently building wealth than on perfectly choosing between investing and paying off debt.
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One of the most common questions we get here at White Coat Investor is whether somebody should pay off debt or invest, and that question can come in a lot of different forms. People talk about whether they should prepay their mortgage or how quickly they should pay off their student loans or those sorts of questions, but the bottom line is they're asking, should I invest this money or should I use it to pay off debt, whatever the debt might be?
Well, perhaps the best advice I can give on this topic is to avoid extremes. What I mean by that is that most of the time when you have this question, there's no right answer. Either one is actually fine, but perhaps five or ten percent of the time there is a right answer. If you're giving up an employer match in order to pay off debt, you're probably making a mistake. You're leaving part of your salary on the table. If you're carrying around credit card debt with a 30% interest rate in hopes that your investments will outperform that, you're making a mistake. So there are some extremes. Avoid extremes when it comes to this question.
Just about everything else in between, I can probably come up with a situation where it might make sense to invest, but where it could also make sense to pay off debt, no matter what kind of debt that might be. Recognize these are both good things. Paying off debt increases your net worth because net worth is everything you own minus everything you owe, and paying off debt reduces how much you owe. Investing increases your net worth because it increases everything you have, so it works on that side of the equation. Both are good things to do, so don't stress yourself out trying to figure out which one to do. They're both going to increase your net worth. They're both good things, and heaven forbid that you choose the second best thing when you have two good things to choose from. It's not that big of a deal. Take a deep breath, relax a little bit, and recognize that there might be one that's a little bit better than the other for you, but it's probably six of one, half a dozen of the other most of the time.
The most important thing when it comes to building wealth, when it comes to reaching your financial goals, is to look at what percentage of your income is going toward building wealth through investing and paying down debt rather than consumption. So let's talk about seven principles that will help you determine whether you should pay off your debt or invest.
The first one is probably your attitude toward debt. Some people just hate it. They absolutely hate it, want to be out of debt just as soon as they can, and will never go back into debt. I'm not quite that extreme, but I don't like it. I disliked it enough that it was a major factor behind why I spent four years on active duty in the military. The more you dislike being in debt, the more you are likely to want to pay it off instead of investing.
On the other hand, there are people who love debt. There are people who think you should stay in debt your entire life. So there's a significant behavioral aspect to this. Sometimes the math would indicate you should carry debt and invest, but behavioral and cash flow considerations often argue for just paying it off. Because yes, if the argument really is pay off debt or invest, you can have the argument, but too much of the time people don't actually invest the difference. They spend the difference. So there's that behavioral aspect of paying off the debt. Your attitude matters.
The second factor is your risk tolerance. If you're not going to invest aggressively, you might as well get the guaranteed return available from paying off debt. If all your investments are things like whole life insurance, CDs, money market funds, and cash under your bed, and you've got debt that's at 4%, 5%, 6%, or 8%, it makes sense to pay off the debt. That gives you a guaranteed return higher than you're making on your investments.
The third factor to consider, the third principle, is what investment accounts are available to you. This had a major effect on our debt versus investing choices over the years. For example, if we had a nice tax deal being offered to us by investing in a 401(k), a Roth IRA, or something like that, we usually took it instead of paying off low to moderate interest rate debt. We paid off our mortgage in less than seven years, but we never put an extra dime toward our mortgage until we had first maxed out all our retirement accounts, our HSAs, and as much as we wanted to give to our kids via 529s and UTMAs and those sorts of things.
The fourth principle to be aware of is your anticipated investment return. That's where the math comes in. If you're expecting to earn 10% on your investments and your debt is at 2%, even if it's a variable 2%, it seems kind of dumb, at least from a mathematical perspective, to pay off the debt. Investments with high expected returns may deserve priority before paying off debt, and vice versa. Bear in mind, of course, that the only returns that count are the after-expense, after-tax, after-inflation returns. Market valuations might play into this as well. Right at the bottom of a bear market, maybe you're better off investing than paying off debt, and at a market high that's been a market high for years, maybe that's the time to be paying off debt rather than investing. There's a lot of factors that go into that. It feels like market timing, and it is, but there's no necessarily right answer to the question anyway. Why not try to time the market a little bit?
The fifth principle is the interest rate of the debt. This is the other half of that mathematical equation. If you've got 8% debt, that's a lot harder to out-invest, especially when you adjust for risk. The investments that tend to beat an 8% debt tend to be pretty risky, whereas getting that 8% return by paying off the debt has no risk at all. Once you adjust for risk, the higher interest rates are a lot harder to out-invest, so keep that in mind. A lot of people talk about, "I'm never paying off this mortgage because it's 2.5%," and that's what they're talking about. They're talking about the effect of that interest rate.
The sixth factor is the level of wealth. You're basically asking yourself, do you need to invest on leverage in order to reach your financial goals? If you're just getting started in life and your net worth is $100,000, it probably makes sense to invest a little bit on leverage, maybe carry that relatively low interest rate mortgage a little longer than you otherwise would in order to invest more money. On the other hand, if you're 55 and you've already got $6 million and you figure you only need $5 million to live for the rest of your life, you have to ask yourself if you want to keep playing a game you've already won. Bill Bernstein would tell you, "When you win the game, stop playing." What he's talking about is stopping the risks like leverage risk that you have from carrying debt. Of course, once you have a significant number of assets, your debt is not really moving the needle anymore. A 1% $30,000 car loan is not a factor in your life when you have $10 million. Even a $300,000 mortgage probably isn't a factor in your life at that level of wealth. The wealthier you get, the less you probably need to be trying to arbitrage the difference between your debt interest rates and what you're going to earn on your investments.
The last factor involves asset protection and estate planning, just to make this decision a little bit more complicated. Not only is this one of the more common questions that White Coat Investors have, but it's one of the more complicated ones. There are a lot of asset protection and estate planning considerations when it comes to your debt. For example, in Texas and Florida, your homestead is 100% protected from creditors in an above-policy-limits judgment not reduced on appeal kind of situation. Those are very rare, obviously, for doctors, but it might cause a doctor in Texas or Florida to pay off their mortgage faster because they know that home equity can't be taken from them if they had to declare bankruptcy. Whereas if you're in a state like Utah, where maybe you only get $80,000 of your home equity protected in that situation, maybe you're a little more likely to invest rather than pay off that debt.
On the back end of life, imagine an 85-year-old not in great health who has a bunch of taxable assets with very low basis, meaning the capital gains, if they sold them, would be very high. They might choose to borrow against the assets rather than sell the assets because the interest is not nearly as high of a cost as the capital gains, and the capital gains will be wiped out when they die and their heirs get a step-up in basis. In that situation, it might make sense not to pay off debt. In fact, it may even make sense to take out more debt rather than liquidating the taxable assets and paying those capital gains taxes.
There are lots of factors there, but in general, you can make a list of the financial order of your priorities. Of course, you're going to put things like getting your employer match at the top of the list and paying off high interest rate debt, anything higher than about 8%, toward the top of the list. Then you're going to get to things like maxing out your available retirement accounts and investing in assets with high expected returns like stocks and real estate. Then maybe you'd be interested in paying off more moderate interest rate debt, like debt at 4% to 8%, before investing in assets with expected returns in that range. Then maybe you get to the lower interest rate debt and the lower expected return assets when you make that list for yourself.
The bottom line is what really matters is how much money you're putting toward wealth building, not exactly where it goes. Just avoid the extremes when it comes to paying off debt or investing. You don't want to be borrowing at 12% to try to out-invest it, and likewise, you don't want to necessarily pay off every cent of your 1% student loans before you ever invest $1. Don't do something extreme, and you'll probably find some place that's going to work just fine for you.
The White Coat Investor Podcast is for your entertainment and information only and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.
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