One of the great things about being a blogger is that I learn something new almost every day. I was doing some research for this post and found that the U.S. total household debt just reached a new peak in the first quarter of 2017. We collectively owe $12.73 trillion and that amount just surpassed the previous peak which was achieved in 2008. That’s over $100,000 debt per household and it is a lot of debt. Most of us have some kind of debt, but it doesn’t mean financial independence is out of reach. We all have to start somewhere. While mulling over where exactly to start, the question many people have is whether to invest or to pay off debt first. This question may seem simple, but it is a bit more complicated that just looking at the numbers.
Here is the debt graph from CMD’s Household Debt and Credit Report (Q1 2017.)
Is it just a math problem?
At first glance, you might think this is simply a math problem. There are only 2 variables here.
- The interest rate you pay on the debt.
- The return on investment.
If you owe $10,000 with a 15% interest rate and the historical ROI for the S&P 500 index averages 10%, then it’s probably best to pay off the high interest debt first. However, it isn’t always that clear cut.
Let’s look at our real life example. We don’t have any consumer debt, but we have 3 mortgages on 3 properties totaling about $460,000. The interest rates on each of these mortgages are around 4%. However, we can take a tax deduction on the mortgage interest for our primary residence. The rentals are even better because we get to write off the mortgage interest, depreciation, property tax, and maintenance expense against the rental income. I don’t like paying interest, but it’s really not bad at less than 4%.
We could sell off some assets and get rid of these mortgages, but then we’d lose out on future stock market gains. At this point, I prefer to pay off the mortgages little by little and stay invested in the stock market. Even if the U.S. stock market slows down and returns 1-3% over the next decade, I still believe it is a good long term investment.
Over the short term, nobody knows what future returns will be. The stock market might return 10% over the next few years or it could return -10%. Paying off the debt is much easier to figure out. If I pay off our mortgage early, I’m guaranteed a 4% return. Now this question turns more personal. You need to look at where you are in life and how much risk you’re willing to take. I’m 43 and I plan to invest in the stock market for many more years. We have 40+ years on our investment horizon and the stock market return should be close to the 10% average with that kind of time frame. For me, it makes more sense to invest in the stock market rather than paying off my mortgages early.
So the answer is different for everyone. However, there are still some basic guidelines we need to follow if you’re putting investing ahead of paying off debt.
Debt needs to be under control
If you want to invest, you need to make sure your debts are under control. Under control means your total debt should decrease every month. This shows that you’re not taking on new debt while you’re paying off the current debt. If your total debt is increasing every month, then it’s not the right time to invest. You need to get those debts under control first.
Here is a common example of debt going out of control – paying the minimum payment on a credit card every month while continuing to use it. First, it will take years to pay off a credit card by sending in the minimum payment. Second, continuing to use the card will increase the total owed every month and likely increase the interest rate along with it. This way of life is not sustainable and it’s no use investing at this point. If your total debt is increasing every month, then you need to figure out how to fix that.
Some investments are just too good to pass up. The 401k employer matching program is one such example. Mrs. RB40’s employer matches up to 5% of her salary when she contributes to the 401k plan. That’s 100% guaranteed return. You can’t beat that with any normal investment. Even if your 401k has terrible investment options to choose from, you should still contribute enough to take full advantage of the employer matching program. You could always put the money in the money market account if there aren’t any better options.
Debt still needs to be under control, though. It’s no use to invest in the 401k if you’re in a debt spiral.
Let’s look at some scenarios.
Early 20s with student loans
Check out the non-housing debt chart below. Unfortunately, student loan debt grew massively over the last 15 years. New grads these days owe a ton of money for their degrees. An average Class of 2016 graduate owes over $37,000 in student loans. It’s tough to start investing when you have so much debt. This makes me glad I graduated in 1996. I think that’s right before college education costs became such a big burden.
It’s really crucial to start investing at this age. The power of compound interest will multiply your investment over time and the earlier you invest, the better off you’ll be. Even if you owe a lot of money in student loans, you need to make investing a priority.
Fortunately, I didn’t owe any money when I graduated in 1996. I was able to start investing in my 401k without having to worry about debt. This might not be true for my son in the future so I’m figuring out my response now. I’d advise him to just make the minimum payment on his student loans and focus on investing in his 401k plan. Here is my recommendation.
- Max out 401k contribution
- Max out Roth IRA
- Split the rest with loan payment and after tax investment
Of course, he’d need to avoid credit card debt while doing this.
Another reason why I’d prioritize investing over paying off debt at this age is because young people need to learn how to invest. Everyone makes mistakes when they start investing and I’m no exception. I signed up with my bank’s financial advisor and invested in some terrible mutual funds. I put too much money in my employer’s stock and made many other basic mistakes. It sucks to make those mistakes, but I’m glad I made them early when I didn’t have much money. It’d be a lot worse if I made those mistakes in my 30’s or 40’s.
If you’re young, prioritize investing over paying off student loans. Equally important is avoiding new debts especially credit card debts. New debts can really derail your future.
45 years old with a mortgage, 2 auto loans, and $16,000 credit card debt
Unfortunately, this is the typical U.S. household. The average family owes $16,000 in credit card debt, $180,000 in mortgage, and $29,000 in auto loans. If this is your household, then forget about investing for now. You need to get your debt under control. Here is what I’d do.
- Figure out why you have so much debt by tracking your expenses and see where the money is going. You probably will need to cut back so you’ll have some extra cash flow. Do what you have to do to make sure your total debt is decreasing every month.
- Pay off the high interest credit card debts first. A typical credit card has 15% interest rate and it’s really difficult to beat that with investments.
- Auto loans. The interest rate on auto loans varies widely depending on your credit score. If you’re paying less than 3%, then it’s probably okay to stick with the payment plan. The important thing is to avoid getting a new car once the auto loans are paid off. Use the extra money to invest and build up a new car fund instead. Personally, I would not buy a car that I couldn’t pay for in cash.
- Mortgage. I think the mortgage is okay. It’s up to you if you want to pay off the mortgage early or invest. Either one is good once you get here.
This is a tough position to be in, but it seems like many families are stuck here. You just have to take it one step at a time and work hard to get out of that hole.
65 years old with a mortgage and about to retire
At this point, I’d take simplicity over optimization. If I have enough cash, I’d pay off the mortgage because it will make retirement life simpler.
- I don’t have to withdraw as much from my retirement accounts. This will give me more control and help avoid the higher tax brackets.
- I don’t have to worry about beating 4%. I’m pretty sure I’d be more conservative when I’m 65 and our returns would drop accordingly.
- Full retirement usually means no earned income so you can’t really invest much anyway. I’d stay invested, but probably can’t add much new money.
It’s really important to avoid taking on new debt when you’re near retirement. Paying off those debts will become much more difficult when you don’t have regular income.
Don’t make enough money to pay for basic needs
I just finished The Unbanking of America: How the New Middle Class Survives. It’s unfortunate, but many families just don’t make enough money to make ends meet. More and more people are depending on check cashing centers and payday lenders. The cost of living continues to increase while wages stagnate. It’s tough out there.
In this case, I’d focus on figuring out how to make more income by getting a better job. Forget about investing until things are better. Investing works best when you can add to it consistently. It doesn’t work as well if you can only invest $5,000 every few years. A better use for this money would be for an emergency fund and anything that can increase your pay. Getting a more reliable car or moving closer to your job would be a good use of that money.
What’s your take?
So that’s my take on investing vs paying off debt. Investing is a better option for young folks and people who are in control of their finances. Paying off debt is better for retirees and people who are in financial trouble.
What about you? Where are you in life and do you prioritize investing or paying off debt?
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