The topic of paying off debt vs. investing is hotly debated, especially among financial planners and famous radio personalities. To give them some credit, they are all correct in one way or another – but the problem with dogmatic answers to this question is that they usually don’t consider the personal part of ‘personal finance,’ nor quote accurate investment data. Debt isn’t a one-size-fits-all topic, nor is investing – thankfully!
Debt pushes today’s expenses into the future, while investing saves for future expenses today.
Is all debt BAD?
Debt is often divided more objectively into ‘good’ and ‘bad’ categories. Good debt means that the benefit of the purchase lasts longer than the indebtedness, the debt is usually secured (backed by an asset), the asset is likely to appreciate and increase net worth, and the interest rate is low (<5%). Bad debt means that the indebtedness lasts longer than the benefit of the purchase, the debt is usually unsecured, the asset is likely to depreciate, and the interest rate is high (>5%).
An example of indebtedness that lasts longer than its benefit is putting the cost of a meal on a credit card, without the ability or intention to pay off the balance before debt incurs interest. The opposite could be said about college education, in which the benefits of the knowledge and professional designations ‘could’ outlast and outweigh the cost of borrowing.
Here are some broad examples of good vs. bad debt:
- Mortgage on an affordable personal residence or rental property
- College loans with benefits that outweigh the total expense
- Responsible small business loans
- Credit cards that carry an ongoing balance
- Automobile loans
- Home improvement loans
- Payday loans
- 401(k) loans, which receive double taxation
Most people agree that paying off bad debt aggressively is a good idea, but let’s get down to the details to determine which debts to keep and which debts to kill.
Always think about your money in terms of time.
Good debt terms usually offer interest rates that seem competitive with expected stock market returns. The problem with this optimism about future investment possibilities is that it is influenced by confirmation bias – the tendency to seek information that confirms an existing belief.
To eliminate this bias, let’s look at real investment returns across multiple time horizons, using the S&P 500 as the ‘market’ benchmark.
I added some color to this chart to show that the risk & return characteristics across multiple investment time horizons are not created equal. If you had decided to invest in the S&P 500 index instead of paying extra principal on a 2-year loan with 4% interest, you would have achieved a better historical average return, but you COULD have experienced annualized returns of -35.2%. Ouch!! That’ll change our hindsight bias.
On the other hand, paying additional principal on a 30-year fixed mortgage with a low interest rate of 3% would have lost almost 100% of the time against the historical returns of the S&P 500 index. This study also makes the case for staying invested in your retirement accounts when the stock market crashes. This risk capacity should be understood when determining your risk tolerance.
Before you make any decisions based on this data, keep in mind that past market returns are not indicative of future investment returns. The only return that is guaranteed is that of your debt lender when you pay interest. Also keep in mind that paying off debt is an emotional decision; for many people, the flexibility and peace of mind that being debt free provides is more powerful than any source of historical investment data.
Final Note: If the company you work for offers an employer match (100% of the first 3%, etc.) as part of your retirement plan benefit, think of that match as a 100% return on your contribution. If your employer offers this benefit, you should still consider investing up to the match as you pay off your debt. Never leave free money on the table! Compounding interest on these dollars is too powerful to forgo.
I hope this risk management concept helps you along your path to financial independence! Feel free to share this with others if it provides value to your journey.