By Dr. Jim Dahle, WCI Founder
Today we're going to address the most common question I see on this blog, in my email inbox, and on forums. Should you pay off debt or use your money to invest? Over and over again it is asked, always with slightly different details. Ninety-five percent of the time, the answer is simple: “It depends.”
Now, let's talk about what it depends on. I wrote about this topic years ago regarding student loans, and I included a chapter on this in The White Coat Investor: A Doctor's Guide to Personal Finance and Investing. In 2017, we actually paid off all of our debt, so we are among the few who no longer have this dilemma. But until you become debt-free, you're going to struggle with this question just like everybody else does, especially if you owe student loans and will have to start repaying them later in 2023. Whatever you choose, make sure you're thinking about debt the right way.
Avoid the Extremes When Choosing Paying Off Debt or Investing
Perhaps the best advice I can give is to avoid extreme positions. Most of the time, there is no right answer, but maybe 5% of the time, there is. If you're giving up an employer match to pay off debt, you're making a mistake and basically leaving part of your salary on the table. If you're carrying credit card debt with a 30% interest rate in hopes that your investments will outperform it, you're making a mistake. But for just about everything else in between, I can 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.
Paying Off Debt and Investing Are Both Good Things
Here's the other thing to keep in mind. Paying off debt is a good thing to do. It builds your net worth. Investing is also a good thing to do. In general, it also builds your net worth. They're both good things to do. At its worst, one is a little more right than the other. If you can't tell which one is better for you, it probably doesn't matter much. If you're really paralyzed from doing either of them, just split the difference and put half of your extra money toward debt and half toward your investments.
Trust me: in the end, this decision isn't the one that is going to determine whether you are financially successful. The important decision is probably what percentage of your income is going toward building wealth rather than consumption.
More information here:
The Nuts and Bolts of Investing
7 Principles That Determine Whether You Should Pay Off Debt or Invest
#1 Attitude Toward Debt
Some people hate debt. I dislike it enough that it was a major factor behind why I spent four years on active duty. The more you dislike being in debt, the more likely you are to want to pay it off instead of investing. Some people love debt. There are even people who think you should stay in debt your entire life. There is a significant behavioral aspect to this. Even though the math would sometimes indicate you should carry debt and invest, behavioral and cash-flow considerations often argue for just paying it off.
#2 Risk Tolerance
If you aren't going to invest aggressively, then you might as well get the guaranteed return available from paying off debt.
#3 Available Investment Accounts
This has had a major effect on our debt vs. investing choices over the years. If we had a sweet tax deal being offered to us for investing, we usually took it instead of paying off debt. Yes, we paid off our mortgage in less than seven years, but we never put an extra dime toward it until we first had maxed out our retirement accounts, our HSAs, and as much as we wanted to give to our kids (529s, UTMAs).
#4 Anticipated Investment
This is where the math comes in. If you're expecting to earn 10% on investments and your debt is at 2%—even if it is 2% variable—it seems kind of dumb, at least from a mathematical perspective, to pay off the debt. In this respect, perhaps investments with high expected returns get purchased before paying off debt and vice versa. Bear in mind that the only returns that count are the after-expense, after-tax, after-inflation returns. Market valuations might play into this, as well. The higher the valuations, the lower the expected returns may be. Eight years into a bull market? Maybe you should pay off your mortgage. Market just dropped 40%? Maybe it's time to invest. Is it market timing? Sure. But if there is no right answer to the question anyway, why not?
#5 Interest Rate of the Debt
On the other side of the mathematical equation is the interest rate of the debt. High interest-rate debt should, in general, be paid off before low interest-rate debt and making investments. Bear in mind the only interest rate that counts is the after-expense, after-tax, after-inflation rate. So, a tax-deductible debt (like many mortgages) is less of a priority than one with an equal interest rate that is not deductible. Likewise, if you have a low, fixed-interest rate debt and inflation is high, well, you're going to be paying off that debt with less valuable dollars the longer you drag it out.
#6 Level of Wealth
Your level of wealth can affect whether you should pay off debt. You've heard the phrase before, “When you win the game, stop playing.” We carried our mortgage a couple of years longer than we had to so we could invest in a taxable account. Then, we became wealthier faster than we expected. It started seeming kind of silly to still be carrying that little old debt around, so we paid it off. But if you have a four-figure portfolio and you are decades away from financial independence, paying off your 2.5% mortgage early probably shouldn't be your priority.
#7 Asset Protection and Estate Planning
Just when you thought it couldn't get more complicated, let's bring asset protection and estate planning considerations into the equation. In some states, your homestead is 100% protected from creditors. If you live in one of those states, perhaps you should prioritize paying off the mortgage a little faster. If you're in a state where it isn't protected, perhaps it is less of a priority. Likewise for paying off debt prior to maxing out retirement accounts with their awesome asset protection and estate planning benefits. What about an ill 85-year-old with some debt but also some taxable assets with low basis? In that scenario, it would make sense NOT to liquidate the taxable assets to get the step up in basis at death. It might even be wiser to borrow against them rather than sell them.
More information here:
How Fast Can You Get Out of Debt?
Financial Order of Priorities
OK, despite reading those seven principles, some of you still can't decide whether you should pay off your debt or invest. You want an algorithm that will tell you exactly what to do. So, I'm going to give you an algorithm and make a list, just like I did on this blog in 2011 and just like I did in my first book. Savvy readers over the years realized those lists were not identical. In fact, they're both different from this list. That reflects the fact that a perfect list can't be made.
But I can guarantee you this: If you just follow this list, you're not going to do anything stupid. Reasonable people are going to disagree with the placement of some items on this list. They may even argue about it for weeks in the comments section. That's fine. But no reasonable, knowledgeable person is going to move something from the bottom of the list to the top of the list. This algorithm is good enough to lead you to financial success.
#1 Get Any Employer Match
Not getting this money is leaving part of your salary on the table. It would be very unusual for you to have a better investment or debt pay down option than this.
#2 Pay Off High-Interest Rate Debt (8%+)
This “investment” comes with a high rate of return, and it's also guaranteed.
#3 Max Out Available Retirement Accounts
- 3(b) — Tax-deferred accounts first in peak earnings years
- 3(c) — Tax-free first in non-peak earnings years
- 3(d) — Include non-retirement tax-protected accounts in accordance with your goals—HSAs, 529s, UTMAs, etc.
This is where most of the arguments are going to be made. The Dahle family funds our tax-protected accounts (Roth IRAs, HSA, (401(k)s, and Defined Benefit/Cash Balance Plan) before investing in a taxable account (and in the past when we had debt, before paying off the debt.) 529 and UTMA contributions may also be prioritized.
But if you're in a situation where you can't max out everything and have to choose, well, there are no right answers. HSAs are triple tax-free, but you can't stretch them or use them very tax-efficiently except for healthcare. 529s are good, but the tax break pales in comparison to a 401(k). Supersavers might benefit more from a Roth than someone who started saving late. Lots of little subtleties there, but the general principle remains—tax protected accounts are great places to invest, and if you don't max them out in any given year, you can't go back and do it later.
#4 Invest in Assets with High Expected Returns
Some more room for argument here. What is a high expected return? Are stocks going to have a high expected return in the near future? What about over your entire investing horizon? What about real estate? Hard to say. But if you're expecting to make 15%-20% on an investment, it can make sense to not pay off 5% debt and invest instead. Heck, if you're expecting 20%, it might make sense not to max out the retirement accounts first (or figure out a way to put the investment inside the retirement account).
#5 Pay Off Moderate-Interest Rate Debt (4%–8%)
I'm often amazed at how many people are willing to carry around debt like this. I still find a 5%–8% guaranteed return to be a very attractive use for my dollars. That investment better be very compelling if I'm not paying off this sucker ASAP. Even in 2023 with cash paying just over 5%, paying off moderate interest rate debt is an attractive option.
#6 Invest in Assets with Moderate Expected Returns
OK, that makes sense. If you expect to make 5% or 6% on something, it can make sense to carry a 2% loan.
#7 Pay Off Low-Interest Rate Debt (1%–3%)
I've never been a huge fan of debt. But I've avoided paying it off a couple of times in the past when the interest rate was really, really low. I would certainly pay it off before dumping a ton of money into a bond fund paying 2% or a savings account paying 1%. Not much arbitrage there.
#8 Invest in Assets with Low Expected Returns
I hope nobody is surprised to find this one at the bottom of the list. In fact, some people might even put “buy a wakeboat” ahead of this one.
More information here:
Financial Waterfalls for New Residents and Attendings
I hope this post is helpful to you as you weigh your own pay-off-debt-vs.-invest decisions. Truly, it depends. Not only is the answer different for different people, but it can be different for you as you progress from one stage of life to the next.
What do you think? When should debt be paid off instead of investing? How would you reorder this list? What would you add to it? Comment below!
[This updated post was originally published in 2020.]
If you’re maxing out all your tax-advantaged accounts each year, have extra money left over, and can’t decide whether to pay off the mortgage or invest in a taxable account, just pay off the mortgage. If you really miss the mortgage, you can always take out another one. But something tells me you won’t…
I think the main problem with no paying a mortgage is if you are going to use the funds to buy that boat. But, if you are going to responsibly invest it, then I do not see why the rush about paying a mortgage early.
I think we all “buy that boat” in some way. I mean, if you went on a vacation this year, you really did it with borrowed money if you still owe money to someone for something.
… true, I am guilty there.
Great post, very helpful and very timely. We have a question about our 401(k) loan. We took a $50k loan for the down payment on our house. We’re two years in and now we have the money to pay it off. Yes it’s at a 4.25% rate, but it’s to ourselves. We need to pay it off within 5 years to avoid tax consequences, but should we pay it off now or wait?
I’d pay it off if you don’t have a better use for your money. I really don’t like 401(k) loans because they become due within 60 days when you are fired/quit and really have a better use for your money.
Here’s a point it took me a while to grasp early in my career. Continually refinancing your home in a declining rate environment gets you a lower rate but resets your amortization table and can decreases the ratio of principal/interest paid.
When evaluating a mortgage payoff vs other options don’t just look at the after expense, after tax, after inflation rate, but look at your amortization schedule and how much of your payment is going towards principal.
For many aggressively paying down a mortgage in order to refi from a 30 yr to a 15 yr mortgage (perhaps after getting below jumbo mortgage level) can be a very smart move. Then you can switch to minimum payments and invest more in taxable account.
WCI (or others) — I’m at #7. Have 28.5 years to go on 3.5% mortgage. Even with the new tax law, at least for a few years I’ll be able to itemize because of the size of the mortgage deduction, though the value of that deduction will certainly decrease.
We already max workplace retirement accounts, backdoor Roth IRAs, and an HSA, and some towards kids 529s (not maxing out but at least meeting our goals).
Since my wife went part-time last year there isn’t a ton of leftover cash month to month for investing vs. paying off the mortgage faster, however that should improve starting in 2019 as kid #2 exits daycare (kid #3 in daycare until 2023), and hopefully with some income increases as well.
I’ve held off on extra mortgage payments until cash flow improves, because I value the liquidity of the cash at the moment, but what I have I would like to invest. On the flip side, I hate having any debt, and the goal is to have this mortgage paid off well before 28.5 years. Any any extra payments I make now will not be substantial though.
Would the collective wisdom recommend just investing anything leftover as a mortgage payoff fund for the future? Or slowly increase the monthly mortgage payments up until it’s a de facto 15 year mortgage and then invest the rest after that? I know there’s no “right” answer here (apart from those who hate 30-year mortgages), but am curious what people think
No right answer. But I kind of like the idea of turning that mortgage into a 15 year.
Long time reader, first time poster. I’d appreciate some input . It’s related to the issue of paying down debt vs investing but maybe more appropriate for the forum instead.
Currently maxing His and Her 403b and 401ks, did His and Her backdoor Roth’s last year for the first time. My student loans are paid off, wife still has a mix of 6.8 and 4.75% left with about $85k due. The 6.8% only has about $5k remaining. Looked into refinancing but the rate was actually pretty comparable and we never did it. Three years into a 30 year mortgage at 4.75% due to lender paid PMI. Once 80% LTV reached will need to refinance. Not sure if we have enough to afford a 15 year refinance or not.
Looking for advise on order of contribution. Enough for my employer match only, pay down her 6.8% interest, then up to max of his and her 403b/401k, then backdoor roth and then 529, followed by taxable?
I posted on bogleheads forum and was led to believe I was crazy for not eliminating all non mortgate debt first.
Thank you.
Dear Dr. Dahle,
I have a question about 15 yr fixed vs 30 yr fixed mortgage. Most people seem to suggest 15 yr rather than 30 yr although the difference in APR is only .50%. I’m a very disciplined investor with no student debt. What are the chances of making less than 0.6% gains (I’m factoring in 20% long term capital gains tax and not considering tax advantage from longer mortgage) if I put the difference in mortgage payments per month in a low cost ETF like VOO.
Isn’t this a leverage opportunity where you are getting a low interest rate loan on your house?
What are your thoughts?
Also, I don’t understand why physicians try to aggressively pay off mortgage rather than aggressively and diversely investing in different opportunities. I agree that student loans with rates of 6.5% or similar should be paid down first as the chances of beating 6.5% considering tax on cap gains can be hard to beat.
But why are people with mortgage rates close to 3% so aggressive about paying down? The inflation rate itself is close to 2% I believe. It is likely to go high in the future and that actually means you are paying less in the future!
I’ll appreciate your thoughts in this. I’m in the process of getting a mortgage myself.
“But why are people with mortgage rates close to 3% so aggressive about paying down? ”
The answer to this question is simple. It’s because paying down a 3% mortgage is a 3% guaranteed return. Nothing is guaranteed in the stock market.
Yes, leverage works. It works both ways, of course. There is also the behavioral aspect to consider. While borrowing at 2% and earning at 7% certainly works, it does require you to actually invest the difference and I think this is where a lot of people fall short. They buy wakeboats instead. And really, if you have a 3% mortgage and own a wakeboat, you basically bought the wakeboat on credit since money is fungible. That reasoning led us to pay off a 2.75% 15 year mortgage 8 years early. But we didn’t pay it off at the first available opportunity, nor did we pass up maxing out any tax advantaged accounts in order to do so.
I think the one glaring omission may be to “fund the emergency fund,” which some other commenters have alluded to. That one should be fairly high up there methinks. Granted, if you have the money to max out retirement account this isn’t likely an issue, but for many it would be more beneficial to have some safely allocated money in a “high” yield savings account than socking it away in their 401k and then having to go to a payday lender to pay for a set of new tires…
I’m struggling with this question recently. I’m conservative, no debt, strictly an index investor. For 2018/2019 tax years my spouse and I will have an opportunity to super charge our retirement accounts by 20,000 more each year because of access to a Solo 401k. We’ll need to make a choice to use our HELOC, at 5% adjusting to max those accounts out or to decide to hold firm. Since we don’t normally have a chance to put anything more than just the IRA’s, it would advance our contributions neary a decade. Add in the tax savings of upper contributions (we are at the line where a 15,000 dollar contribution will shift our tax bill 4,000 the first year alone once you take into account health insurance). After the 2 years is over we’d pay it back down aggressively because we would have lost the option for the heavier investing.
It’s hard though, to commit to a 40,000 mortgage again. It feels like a real step backward.
I agree. That sounds like a step backward. Why are you doing this again? Do you really need to take this leverage risk to reach your goals? I certainly wouldn’t borrow at 5% in order to buy stocks, even in a tax-protected account. Maybe at 1-2% and at a different time of my life you could have talked me into it, but not now at any interest rate.
It’s true, I don’t NEED to, necessarily.
Normally, we are limited to the IRAs for tax advantaged investing. These two tax cycles we’ll be able to max out on the Solo 401ks, roughly 400% of what we can do normally. If we choose not to do it, it will be a decade before we are at the same level of contribution we could achieve now… and that’s assuming that we are not investing for that decade any further.
At the same time, we are at exactly the right amount on taxes that putting an additional 15,000 into a retirement fund saves us at least 30% off the tax bill for those two years. We cross a couple of health subsidy thresholds, savers credits, etc. My numbers for the first year show a 4,000 savings and I’m assuming similar the second. If the total borrowed over two years is roughly 30,000 at 5%… well, it’s a long time before the tax savings alone isn’t paying my way.
The main push really is that with the limitations normally around 11,000 and these couple of years the numbers are closer to 50,000 I am thinking that it’s worth a couple of extra thousand in interest to be able to get long term (30 years) of retirement savings. This opportunity is extremely unlikely to come again so it’s a one off and because we are so long from accessing retirement, I’m not concerned about current market trends. Of course, I still plan on paying it off within a few years once the opportunity is gone.
If you see a basic flaw in the numbers, cough it up. 🙂 My conservative bent doesn’t like to take on debt but when I weigh the two options it seems that one has serious financial advantages.
I once borrowed to max out Roth IRAs. It was at 0% for less than a year. So I can’t criticize you for taking on this risk. But 5% would talk me out of it.
Great post and very helpful for my family (30 year old dual-physician household, both currently in final year of fellowship, planning for 2 kids in the next 5 years).
Just had a question:
In the hypothetical case of a 4% 30 year $400k mortgage, shouldn’t we also take into account the expected home price appreciation (over the long run) when determining if we should pay the mortgage off early? For instance, if we add in $1k/month in payments, that extra equity in the home also appreciates with the value of the house (conservatively 2%/yr ). So wouldn’t the true return on the extra money allocated to the mortgage monthly be 6% (4% + 2%)? This may be particularly relevant for families intending to sell the home in 10 years (at which point the extra $1k/month would translate to substantially more equity than without these payments).
I am probably mistaken in my analysis above, and appreciate your thoughts. But If it does translate into a 6% expected return, then that may change the order you have outlined in your article for some home owners (such as those who have already paid off their student loans).
The mortgage is completely separate from the home. No reason to look at them together. The home will appreciate as it does whether it has a mortgage or not. A mortgage provides a bond-like guaranteed return no matter whether the property appreciates or depreciates. Totally separate.
Excellent Post – I suppose one could argue whether you take certain steps before or after other ones. But the the small things just don’t matter as long as you are investing/paying done debt with a significant portion of your salary.
I paid off a 2.6% fixed Home Mortgage to become completely debt free about four months ago. Some could argue better returns in the market place but it just felt damn good to have no loans over my head. I have maxed out all my retirement options for years and suppose I will start doing a taxable account as well. Another great side effect of being debt free and maxing out investments every year is that it creates a life long behavioral pattern. Now that I have so much excessive cash flow I still live my life the same as when I was two years out of school.
Holy dude congrats on paying down the mortgage. I myself would have not done so just b/c I chose to invest instead of pay down debt, but did you do #4 above regarding anticipated investment? did you hold off on paying off mortgage and used some of that dry powder to invest when the market was done in March? and then when the market came back up to its pre-corona level is that when you decided to pay off the debt? If so great job man!
Holy dude congrats on paying down the mortgage. I myself would have not done so just b/c I chose to invest instead of pay down debt, but did you do #4 above regarding anticipated investment? did you hold off on paying off mortgage and used some of that dry powder to invest when the market was done in March? and then when the market came back up to its pre-corona level is that when you decided to pay off the debt? If so great job man!
Jim great post as always. I have to say that I have been doing this month some of #4 regarding anticipated returns. My written financial plan says to not paydown debt and invest with any extra cash that might happen to be lying around, but when the market kept climbing I felt like I’m not gonna great such great returns investing so I paid down 2.6% debt instead. I am market timing! which brings me to an incredibly nuanced and nit-picky question- is there an optimal timing strategy when using principal #4 to “market time” when to pay off debt vs invest? should I used a 100 day moving average or something? when above the moving average, pay off debt, and when below, invest? Probably doesn’t move the needle much but I’m sort of obsessed with optimizing and squeezing out every dollar I can 🙂
Not sure anyone has looked at that, but it seems reasonable.
Nice hiking photo! Looks like Parker Ridge overlooking Saskatchewan Glacier to me, am I guessing right?
Good eye.
Trying to figure out if I should pay down a six-figure mortgage at 3.6% fixed. We’ve been in a bull market for seven years, I don’t have much bonds to sell off and I’m thinking selling stock right now may not be a bad idea. Of course I would take the capital gains hit, though I’ve done well on these investments in the bull market and think it complies with the principle of selling high
If you’re having worries like this, it may indicate you need a less aggressive asset allocation. This is certainly a much better time than March to dial back your asset allocation. When you win the game, stop playing etc.
You’re also weighing one goal against another (larger retirement portfolio vs paid off mortgage.) Only you can decide what you value more.
Retired financial advisor and MBA with 25 years experience in financial services here. Some good points were presented in the article but I would emphasize for the top (or very near the top) of every investor’s to-do list the establishment of a liquid, zero-risk emergency fund; think bank savings account or government-backed money market fund. Shoot to build up six months worth of monthly expenses and maintain that level at all times.
Not sure how important an e-fund is for someone that is financially independent. I mean, if you’ve got $800K in a taxable investing account you can probably drop the $30K e-fund, no?
But for most investors, agree an e-fund is pretty important early on.
Many of us who purchased homes in the past few years have a different situation— we’re locked into ultra low interest mortgage rates (sub 3%) in a high interest world.
When deciding on moving to new house (with higher mortgage rate) or paying down mortgage, how do you value such debt with a NEGATIVE real interest rate? Does it basically transform into a low interest, no risk asset?
It didn’t transform, just your opportunity cost changed. Lots with very low interest rates will make a different decision about debt vs investing than they might have made 3 years ago or 3 years from now given that one can make 5% on cash right now, at least pre-tax.
Happy to see your advice on 1-3% debt seems to have softened a bit. Student loan debt at 1.6% and mortgage at 2.2%. Even after doing well financially 15 years into practice I still can’t imagine paying those off early. I’m on target to finish paying my student loans at 60. Possibly after I retire! The only “leverage” i have but still think it’s great debt. Plus the student loan debt is like a small life and disability policy!
You bet me in one of my comments that at some point I’d get annoyed by that student debt and just pay it off. Possible but still not there! Especially when cash is 5% now.
My advice hasn’t changed a lick. Interest rates and inflation changed.
Personally, I’d probably still pay off 1.6% student loans and a 2.2% mortgage. I certainly would have paid it off 2 years ago when my cash was only making 0.8%. But I don’t think it’s crazy to carry that if you need to use leverage to reach your financial goals. I no longer need to do that.
The bet still stands. What did we bet? A drink? I think my med school classmate neighbor still has $10-20K in student loans at 0.9%. I tell him the same thing.
Stop trying to peddle your books etc. just follow the Dave Ramsey method. It’s better than your advice in this article for sure. There’s a reason doctors aren’t even in the top 5 professions for being asset millionaires…. It’s articles like this
“Stop trying to peddle your books etc.”
So you don’t want me to run a business? You don’t want me to make money? You don’t want me to make payroll? What exactly is it that you think I’m doing here? WCI is a for-profit business and we don’t plan to change that any time soon.
“just follow the Dave Ramsey method”
I’ve addressed what I like and don’t like about the “Dave Ramsey method” elsewhere on this site:
https://www.whitecoatinvestor.com/22-things-dave-ramsey-gets-wrong-and-right/
https://www.whitecoatinvestor.com/how-dave-ramsey-may-be-leading-you-astray/
https://www.whitecoatinvestor.com/dave-ramseys-baby-steps-are-too-rigid/
https://www.whitecoatinvestor.com/dave-ramsey-asset-allocation/
https://www.whitecoatinvestor.com/dave-ramseys-bad-advice-about-pslf/
https://www.whitecoatinvestor.com/raising-rent-dave-ramsey/
https://www.whitecoatinvestor.com/dave-ramsey-doubles-down-on-his-bad-investment-advice/
“better than your advice in this article for sure…It’s articles like this”
How about talking about exactly what you think is wrong and we can debate ideas instead of doing the anonymous ad hominem thing?
The reason doctors aren’t in the “top 5 professions for being asset millionaires” (something Ramsey did a survey on recently) is because there aren’t as many of them as there are other professions like teachers etc. A doctor is far more likely to become a millionaire than a teacher, but there are just so many more teachers out there. But if this is like most of Dave’s surveys, it doesn’t exactly meet the rigors of a statistically high-quality study. If you think it’s easier to become a millionaire as a teacher than a doctor, you’re a fool. Half of our audience are millionaires and most of the rest soon will be.
I have a slightly different question that I could not find an answer to. If someone is going to be unemployed for a year or so, is it better to fund living expenses by selling investments that are in a taxable account or take out equity of their house and refinance? thank you
Well, the nice thing about spending from the investments is that you may be able to get into the 0% LTCG bracket. Plus no risk of losing your house nor paying additional interest like you would with using house money. I’d hate to see someone refinance from a 3% loan into a 7% loan long term like they might right now too.