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Pay Down Debt or Invest?

Often, after making a financial turnaround, people have one big question: Where should the extra money go? Should I pay down debt, or should I invest?

Mathematically, the analysis is simple: Put money toward whatever option will earn the greatest after-tax rate of return. Once you’ve exhausted that option, move on to the next best.

Of course, there’s no way to know for certain what an investment is going to earn over a given time frame, so you have to do a little guessing. My general framework is as follows:

1. 401(k) Match

Priority #1 should be to take full advantage of your employer’s 401(k) match. It’s an immediate 100% return, guaranteed. (In fact, if you qualify for the Retirement Savings Contribution Credit,  you could be getting a guaranteed return of 110% or 120%.)

There’s just no beating that.

2. High-Interest Debt

After exhausting your 401(k) match, high-interest debt is the next in line. Paying off consumer debt is equivalent to getting a guaranteed after-tax return equal to the interest rate.

In my opinion, any nondeductible debt carrying an interest rate of 7% or more is worth tackling before any further investing. Guaranteed 7% after-tax rates of return just don’t occur anywhere else.

3. Retirement Accounts

After eliminating high-interest debt, it’s time to move on to tax-advantaged investing via an IRA or 401(k) account (or other employer-sponsored retirement plan).

Due to better investment options and lower costs, it’s generally best to max out your IRA before maxing out your 401(k). (Also, for many investors, a Roth IRA is more tax advantageous than a 401(k) account.)

4. Mortgage

Mortgages tend to carry significantly lower interest rates than other debt due to the built-in collateral. Also, home mortgage interest is (somewhat) deductible. As a result, the after-tax rate of return earned by prepaying a mortgage tends not to be as high as what you’d earn via a diversified portfolio in a tax-sheltered account.

That said, there’s still something wonderful about a) knowing what rate of return you’re going to get, and b) being completely debt free.

5. Taxable investments

For most people, I tend not to recommend bothering with taxable accounts until practically all debt has been paid off and every tax-advantaged avenue for investing has been exhausted.

[Exceptions: 1) building up an emergency fund, and 2) investors who intend to retire prior to 59.5]

6. Subsidized Student Loans

Federally subsidized student loans carry a very low interest rate. Further, that interest is tax deductible (regardless of whether or not you itemize). Call me crazy, but at an after-tax interest rate of less than 2%, I wouldn’t pay so much as a dollar beyond the monthly minimum payment.

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  1. What’s great about this is that it’s simple and straight forward. Your arguments are compelling too.

    Some folks could argue that investing (even in taxable accounts) is better than paying down mortgages. I would not agree with them and would agree with you. I paid off my mortgage and feel free beyond description. I don’t care about the returns on my money….how about returns on my life?

    While it might make more sense financially to invest and have debt, the emotional payoff is great.

    I think this is a function of your life experiences.

  2. The argument that some would consider debt-reduction as an additional form of investing as generating 5% interest while losing 10% interest has always made sense. The succint summary is found in saying “Put money toward whatever option will earn the greatest after-tax rate of return.” C’est Fini!
    Fortunately for me at the moment things are simple as I only get to worry about 2, 3 and 6. I’ll remember this though.

  3. I’m in total agreement with Wealth Pilgrim on Item 4.
    I am currently paying down my mortgage as quickly as possible. I pay a minimum of $1k per month to the principal and any net bonus money on top of that. With just over $32k left on the note, I don’t earn enough interest to see a benefit to itemizing my deductions. So paying down for me is 5.58% net return on my investment.

    401k has been ongoing for 18 years (smartest move I’ve made financially)
    Emergency fund, I robbed 6 months from it to pay off CC#1, currently at 6 months. See Damilola’s comment above about earning interest while losing a greater % in interest.
    CC#1 paid off, Jan 2009
    Car loan paid off, March 2009
    CC# paid off, May 2009
    Fully funded Roth IRA, June 2009
    Mortgage, projected payoff April 2012

  4. Great post. I’m in full agreement. I would only add another bit on the advantages of a Roth: (1) you can withdraw your contributions penalty free, (2) you are not obligated to take distributions at any age, (3) you can use the funds for college expenses penalty free, (4) there are few other penalty-free ways to take early distributions (e.g. for first-time home purchase).

    If one qualifies for a Roth (or one can use the back-door funding method available beginning next year), it is a very good way to save.

  5. I agree with the order you gave, Mike.

    As always, I think you need to take stock allocations into account when making this sort of decision. The historical data indicated that stock investing was a bad bet from 1996 through 2008. A lot of people have a hard time with the idea of being out of stocks for 12 years. But I viewed this strange time-period as a great time to pay off debt, including mortgage debt.

    I calculate the likely 10-year return on stocks starting from the price level at which they are available and then compare that to the “return” I obtain from paying off debt (including mortgage debt). If the interest rate on the debt is higher than the likely stock return, I think it makes sense to pay off the debt.


  6. I agree, however, I feel that you can’t beat investing in the market these days. With the avg below 10,000 you are getting a great deal on stocks and I think it would be foolish not to invest at least a little bit. If it takes you 5 years to pay off all your debt, do you believe the market will still be below 10,000?

  7. Rob Bennett says

    With the avg below 10,000 you are getting a great deal on stocks and I think it would be foolish not to invest at least a little bit.

    I agree with you, Michael. Stocks are today priced to provide at least a decent long-term return and perhaps something a good bit better than that. My only caution is that we may be seeing more big price drops over the next five years. But so long as you are sure you can hold for at least 10 years, I think it makes sense to have a significant portion of your money in stocks at today’s prices.


  8. The position you put forth in this article is nearly identical to the position I hold with my debt/investment strategy.

    I wholeheartedly believe that people need to get rid of all their high interest debt before attempting to “invest.” Why? Well, because 9.9 times out of 10 they will “pay themselves more” by ridding themselves of the debt first.

    My one difference (although I could be swayed by some cold hard facts) is that I believe paying off high interest debt trumps even contributing to an employer matched 401k. Partially due to what I mention above, and partially due to the fact that the majority of employees will never reach the employment tenure necessary to become fully vested… especially in this modern work world.

    Great info here, I’m glad you spelled it out… this topic is something I have been wanting to address myself lately.

  9. Michael: You raise a good point. If I’m honest with myself though, I have to admit that I have absolutely no idea where the market will be in five years.

    Matt: Too true. My discussion of employer 401k matches assumes that the employee is already fully vested. My experience suggests that the majority of employers have 401k plans in which the employee is immediately 100% vested.

    That said, my experience is purely anecdotal, and I haven’t seen any broader studies done that either prove or disprove that claim. (If anybody has a link to one, please share!)

  10. Heh… I wish that were my experience. Every employer I have worked for has used the growing percentage approach to employee vesting. 1 year = 0% vested, 2 years = 20%, 3 years = 40%, 4 years = 60%, etc.

  11. Yeah, that’s how my wife’s 403(b) works as well. It leaves something to be desired. Yet
    a) Even at two years (20% vested), it becomes a better option that paying off many credit cards, and
    b) It’s better than nothing! 🙂

  12. Yeah, perhaps it does. The thing is… it is just better for me personally to pay off the debt. It will be gone within the next 10 months (hopefully the next 4 depending on how fast my blog income grows) and I am comfortable starting my 401k contributions after that.

    Personal finance is always personal and the emotional victory of debt elimination is more valuable to me than a few bucks on a 401k match. But this will of course differ from person to person.

  13. Just a quick note, the amount you can deduct from your student loans is directly tied to your MAGI. I learned that the hard way when I graduated law school making more than what is allowed. No one told me that at the bursar’s office! That may change your order regardless of whether it is subsidized or not.

  14. Regarding the student loans….subsidized loans have another benefit that shouldn’t be overlooked — they allow deferrment, forbearance, and even cancellation (in limited circumstances).* How many other loans have policies that allow you to stop making payments — with no negative impact on your credit rating — if you lose your job, get sick, or go back to school?

    No debt is good debt, but during uncertain times like today’s job market, these “safety net policies” have caused me to deprioritize my student loans in my debt elimination schedule (well, these policies and the really low interest rate I have!)

    * It should be remembered that interest continues to accrue during a deferment or forbearance.

  15. My emergency fund is topped off and so is my 403(b) match; my only debt is my student loan. If I follow your order, it looks like I would 1) max out the IRA 2) save for a 20% down payment for a home in my taxable savings account 3) pay off my student loans. Is that what you’re suggesting?

    (I’d be happy to rent nearly forever, but we also want our own land to grow our own food, which is not really available to rent, nor can rented land get the benefit of building soil over decades.)

  16. tg: Based on the information you’ve given, that’s very nearly what I’d do in your situation. I’d probably come back to your 403(b) and max it out completely before making any extra payments on the student loans. (Whether or not I’d do that depends upon the student loan interest rate and upon the administrative fees and quality of investment options in your 403b)

    Of course, I can’t promise that it’ll end up being the single best decision. (There’s no way to know for sure without knowing what each asset class–stocks, bonds, real estate, etc–will earn in the future.)

    Either way, sounds like you’re doing well already. Nice job. 🙂

  17. Super post. When I finish my borrowing to invest article I think I’ll do a take on this for UK investors. Will link to you for my US readers’ benefit. 🙂

  18. I believe that persons should pay off their debt before investing. Having debt and concentrating on investments will place added stress on the individual. Being debt free will allow this individual to make concise and practical decisions regarding the investment(s) he/she has interest in.

  19. One thing you overlooked with debt is debt that has a low rate. Presently I have credit card debt at 0% until March 2010. While I will not be paying the debt off by the expiration, I do plan to move it to another card, preferably with 0% or a very low rate. Given this, does it make sense to pay down a balance during the 0% time frame, or would the money be better invested in an emergency fund? I have been investing money in an emergency fund while my debt interest is at 0%. What’s your opinion in this case?

  20. Nancy, good question.

    I’d probably cap the emergency fund at $1,000 or so and work toward paying off that debt ASAP. As it sounds like you’ve figured out, you won’t be able to keep it at 0% forever.

    Yes, you’ll be paying a loan that’s currently at a 0% interest rate and forgoing whatever interest could be earned on a savings account. But the way I see things, credit card debt (even if it’s temporarily at 0%) is something you want to get out of as quickly as you can.

    Alternatively, go ahead and put all the money into your emergency fund (assuming it’s in something that earns interest) and then a month or so before you have to transfer the debt to another card, use all the emergency fund money (except $1,000 or so) to pay off as much of that card as possible.

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