Invest or Pay Down Debt- Why Investing Always Wins

Here’s one true hack I’ve utilized to increase my net worth over $7,000 in 2015 and again another $7,000 in 2016. I’ll dive into the details below but here’s the conclusion: investing always wins. So, the next time you’re asking yourself if you should invest or pay down debt, then click back to here and read below.

Invest or Pay Down Debt: Why Investing Always Wins

How can I guarantee a better option when everyone knows paying down debt is a great route?

“Paying down debt is a guaranteed return while investing is a gamble and can’t promise you anything!”…I hear you, and if you’re concerned about the risk, then read on.

I can show you the numbers and you can decide for yourself.

Most Millennials have it backwards: They place getting rid of debt as a higher priority than maximizing wealth.

The result is payment of tax efficient debt in a tax inefficient manner. This approach lessens the opportunity to achieve financial independence or early retirement.

5% Example

An extra $1,000 to pay off a mortgage or student loans means you’ll save $50 on interest, assuming a 5% interest rate. If you place the same income into your 401(k) then it is pretax, so $1000 is actually ~$1,300 (25% tax rate). Adding in $40 net interest because and you’re saving $260.

With the second tax-efficient approach, you’re saving an extra $210 on your $1,000 decision for an immediate 21% return.

Compare this with the less effective, non-Distilled-Dollar approved approach of spending $1,000 to eliminate a $50 expense, or a 5% return.

What About Taxes?

If you’re concerned about the future tax costs, then check out this article on how to access retirement funds early. With strategic financial and tax planning, we can experience a $10,000 net worth increase in a year or two.

As mentioned above, the net benefit on interest is often slightly lower if we decide not to pay off the loan. In the 5% example above, the $50 spent on interest earns me a $10 reduction in my total tax bill. So the net benefit is $40 when compared with the alternative approach of investing and gaining that $10 benefit.

Outside of the monetary gain, the intangibles of utilizing the tax system while investing in your future have a positive impact on any individual, and in many cases, a couple or a family.

When I think of, “What makes me excited about personal finance?”…the clear answer is strategies such as this one!

Applied on a personal level, this strategy has increased my net worth by an extra $14,000 in the previous two years alone.

More importantly, strategies such as investing first have removed the stress of student loan debt in my relationship & it has given my fiancee and I confidence that we’re ready for the next steps in life (e.g.. home ownership, family, taking care of our parents, adopting our third-fourth-and-seventh-cat, etc.).

What about Lower or Higher Interest Rates?

 With lower interest rates, this approach works even more effectively because the threshold for stock dividends has typically been around 2% in the past. What this means is a $1000 investment in Vanguard’s Total Stock Market Index (also called VTI) will net us approximately $20 in dividends payments in the year. This is completely separate from the exposure we experience as markets move up and down.

With higher interest rates, of say 10%+, then I would STILL suggest this approach because we have options to refinance.

If you’re concerned about a total inability to refinance because you recently went through a bankruptcy for example, then I would advise paying down the debt first. If you have any chance of refinancing, then consider this approach if you want to optimize your net worth instead of focus on eliminating debt only.

So the next time you’re thinking on how to pay down debt to maximize your net worth, then consider the hybrid approach and think of the numbers above: Invest what we can today and let low interest debt fuel our path to early retirement.

Do you prioritize your investments and your net worth over your debt? Are you focused first on destroying debt before moving into the investment territory (if yes, reread this post and start investing!!)?

-Matt

12 comments… add one
  • FullTimeFinance Jun 27, 2017, 6:17 am

    One of my financial mistakes was paying down student loans instead of capturing my 401k match when I was younger…. but.. life is not all math related. Paying off debt can yield psychological dividends like less fear, decreased risk of pulling money out during a market pull back, and other potential person specific impacts. As such it’s not necessarily as clear cut as the math predicts imho. I don’t have to choose between tax advantaged accounts and debt. But I do often choose debt over normal taxable accounts. Why? For the psychological impact. It’s like the bond allocation of my investments.

    • Lance @ My Strategic Dollar Jun 27, 2017, 8:13 am

      I generally align with Matt on this one. Depending on the interest rate, if you can earn more interest than you’re going to save it’s in your best long-term interest to invest the money instead of using it to pay off debt. Of course you should pay off high-interest consumer debt – no doubt about that.

      That being said, I understand the psychology behind paying off debt. I paid off a large number of student loans before refinancing. But that was a combination of wanting to eliminate the smaller loans, and taking care of the loans with the highest interest rates.

      If it makes you feel better, by all means pay off your debt. Just know that you’re actually choosing current feelings over larger long-term gains. And there’s nothing wrong with that since personal finances are, personal.

    • Distilled Dollar Jun 27, 2017, 8:28 am

      I see your point and for this post I’ll just add- what about the psychological benefits of having a higher net worth vs lower debt? Could I argue the same approach from the perspective of “higher net worth = more security and certainty long term, etc.”?

  • Apathy Ends Jun 27, 2017, 6:41 am

    You can’t see me but I am cheering!

    The tax benefits are often overlooked/ignored when making this decision.

    I advocate for investing over paying down debt for anything 5% and under. Historical long term gains are over that amount and the tax savings you pointed out make that an easy decision for us.

  • Brad - Maximize Your Money Jun 27, 2017, 6:56 am

    I’m 100% debt-free with no regrets. Similar to FTF’s comment, being debt-free allows me to be fully aggressive with the rest of my assets. 100% stock, no bonds. During corrections – that always happen – the fact that I have no debt payments helps me hold strong and not sell anything.

  • Penny deSaver Jun 27, 2017, 7:27 am

    I agree. I see at it as a game – so the more favorable interest rate usually wins. We use the 5% rule at our house too, just because it’s an easy number. If an interest rate is less than 5%, we pay as agreed and save/invest the rest. Above that (which we thankfully don’t have now) we pay down quickly. For example, I needed to take out a medical loan several years back. The interest rate was almost 10%! – we got rid of it in about a year. However, our mortgage is only 3.2%. We’re paying that as agreed.

    Anyways, I love that you wrote about this. I see so many people aggressively put all their money to their debt without always having a bigger strategy behind it.

  • Ryan @ JustAnotherDollar Jun 27, 2017, 7:45 am

    I can definitely agree with your logic here, which is part of the reason we will be changing gears in August after we pay off our credit card and car debt. For the next year we will primarily be saving in our 401k’s and building a down payment to invest in an income property rather than aggressively paying down our student loan debt.

  • Terry Jun 27, 2017, 9:52 am

    If we are already maxing out our 401k pre-tax contributions, should we prioritize student loan debt elimination over additional after-tax retirement savings or does your principle still apply? We have approx. $88k in private loan student debt that is at 3.25% fixed.

    • Distilled Dollar Jun 27, 2017, 11:04 am

      3.25% is so low that I would invest over paying down the debt. That’s me so not sure if that fits your budget/lifestyle.

      If the market return is lower than expected, I can still count on dividends being around 2% per year. Historically speaking, this move opens me up for expected higher returns over a long term horizon, as high as $10,000’s+ …while only leaving the $2860 from the interest on 88k. Also, the interest will likely have a slight tax benefit which helps.

      Long story short, I would be happy exposing up more risk by keeping the 3.25 loan, given that I can healthily pay the interest and given the investment will be in the market for 10+ years.

  • Brian Doyle Jun 27, 2017, 2:21 pm

    I go back and forth with this dilemna all the time. Should I dump the extra 100-200 into my 401k, or make a double payment on the car? I think short and long term goals heavily weigh on this question. If you want to retire early, invest. If you are trying to improve your credit score as fast as you can for a big purchase, pay off as much debt as you can. If you’re short term goal is to buy an income property, you should probably be stashing the money away for a good down payment. Many different approaches, but I liked your data to support investing. Thanks, man!

  • Marie Jacobs Jul 15, 2017, 10:42 am

    I absolutely agree to not stop investing while paying off debt especially if giving up company match! But after contributing to our tax advantaged accounts we are paying down our mortgage for the simple math that our monthly principal and interest times 12 months times 25 (@ 4% withdrawal rate) is over $75 thousand MORE than the principal balance left. Our timeline is too short for the interest rate spread to make that up so why save more than we have to just to keep the debt around? Keeping the debt makes sense if the goal was a higher net worth in 20 or 30 years but not necessarily if it delays FIRE by an extra year or two to fund 25 or more times the added monthly expense.

    • Distilled Dollar Jul 16, 2017, 9:44 am

      Hey Marie! I agree since you mentioned the timeline wouldn’t allow for the investments to pay off. If you need the money on a short horizon of 5 years or less, or even 10 years or less, then investing would not be the best route to go, as it pays to be a long-term investor.

      I’m in a similar boat on the mortgage topic and now that the DD household will soon carry a mortgage…I’m not 100% sure which way will go in terms of trying to eliminating the debt asap or if we wait as long as possible and invest the difference. I’m thinking we’ll end up going with the latter route. It looks like our mortgage will be close to 4% so a 2% annual dividend from VTI means we’ll only need a 2-3% stock market return to really start to edge out in front.

      Thanks for the comment Marie!

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