Why investing can be better than repaying debt

Young man scratching his head

It's a difficult choice: On the one hand, you understand the need to begin investing early to make the miracle of compounding work for you; on the other hand, you know that, when you have debt, making those payments hampers the ability to harness the miracle of compounding.

So, what should you do with that $500 you have — invest it or pay down the debt? The answer is not as simple as some make it out to be.

Reasons to repay debt first

1. Risk of disaster

As I mentioned in the article about starting to save for retirement, life is not always fair or kind. Most of us depend on a paycheck for everything: rent or mortgage, food, gas, utilities and so forth. When something happens, like losing your job, divorce or severe illness, those checks get smaller, or may even disappear temporarily. We can cut back some of our expenses like gas, clothing, etc. But some things are impossible to cut back. That list is usually headed by rent or mortgage payments and those monthly payments all other forms of debt require. You can't cut those back in times of trial.

It gets worse: The banks or credit card companies who lent you the money become adamant about repayment. If you have a car loan, they can come and take away your wheels.

Therefore, the first reason to put debt payment first on the list of things to pay is to remove the risk of bad things happening to you in the event of some unforeseen disaster.

2. Interest

You pay interest on the money you borrow — usually a much higher rate of interest than you can count on for your investing. Let's say your car loan carries 8 percent interest. In effect, any payments you make on that loan will earn you 8 percent … usually much more than the 2 percent or so you can earn on a CD or savings account.

3. Lifestyle enhancement

The discipline to repay debt and then stay out of it spills over into a mindset. That debt-is-bad mindset inevitably makes you question impulse purchases, which is often the number one reason people incur consumer debt. Instead of getting that new Lexus with a $399 monthly lease payment, you find a used Honda Accord you can buy for cash, or a much smaller (and shorter) loan. After two or three months, you discover you're actually not losing out all that much by eschewing the Lexus. You pat yourself on the back; and next time the temptation to get into debt arrives, it becomes easier to escape.

Another example: Instead of putting a well-deserved Caribbean cruise on your credit card, you set up a savings account to do it next year. By the time next year rolls around, you have thought of a few other vacation options, some nicer and some cheaper. You end up feeling better after a nicer vacation … and no debt.

4. Freedom

Making payments is a prison. Sure, they let you go home, but your movements become very restricted. There are many unforeseen opportunities which cross our radar every day such as the imminent Ferrari IPO. Wouldn't it be nice to get on board with one of the most sought-after brands in human history, and possibly triple your money like those who could jump on the Facebook IPO did? Or let's say a coworker has a situation come up where they can't take the lovely vacation for which they have already paid. You can pick it up for a third of the price, but you have 24 hours to jump.

If you are making payments, you can only press your nose against the window pane and longingly stare at those opportunities like a poor boy at Christmas. With no payments, though, you would have the freedom to at least consider them seriously.

Those are four powerful reasons for making repayment of all debt your top priority, and relegating investing to second place on your financial priority list.

Not so fast. Nothing in life is ever simple (other than buying chocolates for your loved one). There is another side to this coin.

Reasons to invest first

1. Compounding

In an earlier post, you saw how dramatic the miracle of compounding is. By way of reminder, here is the chart:

You might be tempted to consider the interest you earn in your first year when you compare your investment earnings with the interest you pay on your debt.

That is a huge mistake!

No matter which year you start investing, you will always get that first year's interest (or earnings). The only thing that changed is when you get it. There is, however, no guarantee you will ever get that last year's earnings. That is determined by how early you start.

What you lose by starting a year later is the last year's earnings. If you start investing a year later, you will never ever get that last year's bumper earnings. If you wait two years to get started with your investing, you will lose the last two years' earnings.

And, it almost doesn't matter what you invest in. Chances are that last year's earnings will be way higher than any interest you pay on debt in the first year.

This is something most people overlook when they make the debt vs. investing interest comparison.

2. The calendar

The two most common retirement investing mechanisms most people use today are employer direct contribution retirement plans, like the ubiquitous 401(k), 403(b) plans, and IRA's. What many people overlook is those plans are tied to the calendar: Once you get past a certain date (usually the 15th of April every year), you cannot go back and catch up. If you made your contribution, it gets on the compounding train. However, if you miss a year's train, it's gone forever.

Once you understand the miracle of compounding as shown in the chart above, you understand how important it becomes to make each year's investment contribution in order to get the full benefit of the final year's returns.

There is also a limit on how much you can contribute each year. In the normal course of events, the calendar and contribution limits do not have all that much impact; but in the event you get a windfall, such as an inheritance, bonus or severance payment, you can't go back and make catch-up contributions to those retirement plans. You can max out this year's contribution and that's it.

However, there is usually no limit to how much debt you can repay, so you can pay back 30 or 40 years' worth of debt with a single windfall (limited only by how big it is).

Of course, none of us is guaranteed any windfalls, but they do happen. Therefore, you could end up much better off if you kept your investment contributions ongoing and used any unforeseen income (big or small) to get ahead on debt repayment.

What should you do?

The smart thing, of course, is not to have any debt, and then invest everything you can. However, if you're unlucky (or late to the financial wisdom party, like I was) you don't have that luxury.

Many people are fervently adamant that one strategy (theirs) is the only way to go. Some say debt has to come first, others insist it pays better to invest first. The truth is that no two people are in the same position and, therefore, there can be no one-size-fits-all solution.

If you put investing first, you stand to have the higher eventual gain; but in order to do that, you have to assume the risk that your income stream will never become compromised. Not everyone is in a position where they can afford to take that risk. Others simply prefer safety today over some nebulous benefit so far in the future that it may never materialize. Your risk tolerance will determine on which side of the fence you fall. You may also find that circumstances may dictate a change in strategy.

For years, my wife and I lived frugally and avoided all debt except our mortgage. However, when the stock market tanked in the Great Recession, I borrowed every penny I could against my 401(k) plan (usually the ultimate taboo) to buy a preferred stock paying 30 percent per year because of the abnormally depressed stock price. I begged and borrowed (drawing the line at stealing) and bought all I could. That was the single investment that turned our fortunes around. As the market recovered, I sold enough to repay all our debt, and still had many times more left over. I've never done that again because some opportunities only come along once in a lifetime. At those times, it's better to be pragmatic than dogmatic.

In the end, each person has to decide which direction their risk tolerance steers them. The best we all can hope for is enough insight to make an informed decision.

Have you been faced with the dilemma of whether to reduce your debt or invest? How did you approach this quandary, and what was the end result? If you had to do it again, would you make the same decision or change it?

More about...Debt, Investing, Planning

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IamNoSpecial
IamNoSpecial
4 years ago

Off the topic: Everybody says that “if you had invested during the recession…” kind of lines. This is the first time that somebody has said that “Yes, I did that”…. Excellent vision…
Regarding the topic, yes I had faced this kind of dilemma. Whatever decision I took, in the hindsight, it would have been better other way round.. but in hindsight…

Ramona
Ramona
4 years ago

My only issue with investing would be that it’s risky. I just think about the VW stocks for instance, after all this scandal. I presume there have been quite a lot of investors who took a hit. Being in debt and losing money like this might prove catastrophic.

William Cowie
William Cowie
4 years ago
Reply to  Ramona

You’re right, of course, and now you can add Walmart to that list. But there are ways to reduce investing risk, like diversification, for instance. Mutual funds (including index funds) offer you great protection against a single stock (or bond) tanking suddenly.

Big picture: no matter what you’re doing now, your final career will be investing, because that’s what you will be living from. In other words, we can’t avoid it, risks or not. Might as well get proficient at it while we can. 🙂

Peter @ How To Live In The U.S.
Peter @ How To Live In The U.S.
4 years ago
Reply to  Ramona

Yes, you are right Ramona. Investing is risky. Except, it doesn’t have to be, but that’s where people throw their hands up and leave it to personal financial advisors to invest their money, resulting in enormous amounts of fees over the years. The problem is that our financial system has become so complicated in the past few years, but it doesn’t have to be. Have you ever been in a situation where you were talking about finances, and a lot of difficult terms were thrown around? During that conversation you kind of scratched your head and afterwards you went home… Read more »

Michael
Michael
4 years ago

I would say it depends on the interest rate, but why not do both? Sure you don’t get the benefit of fully paying the debt or fully saving the funds, but it does give a little bit of the best of both worlds. When I had student loans (that were at 6.5%) I was actively paying them down. If I had an “extra” $500 I would put $250 (possibly more) towards the loans and the remainder into investment. After all, the money paid towards the loan was an instant savings (as I’d be paying less interest). However, my mortgage is… Read more »

Kalie @ Pretend to Be Poor
Kalie @ Pretend to Be Poor
4 years ago

We’ve gone back and forth about investing vs. early mortgage payoff. I agree the numbers are in the stock market’s favor. When stocks dropped we put more toward investment and slowed early payoff. But the appeal of having no debt is strong for us, and since my husband’s new company wasn’t matching his 401k for the first year, we’ve been focusing on getting rid of the mortgage, which we should be done with in less than a year.

Brett
Brett
4 years ago

I am very much an advocate of debt reduction, however I like the idea of scarcity in typical investment vehicles most people use. So long as the debt is low-interest and manageable, making sure you can exercise all of your 401k matching and Roth contributions is a once a year opportunity. Once it is gone, that is it! Debt (as we all know) will always be there until we pay it off. Great insight!

Adam
Adam
4 years ago

Obviously this changes with high interest debt or if there is no need to pump even more into your retirement account but… I prefer investing and here’s why… The only way to come out ahead after paying off the debt is if the interest rates on the debt were higher than your investment returns AND once the debt payments are over, if you invest that entire amount. I think that it’s likely that many people will get rid of the debt payments, use half of that money on lifestyle inflation, and then be behind in their retirement accounts. I also… Read more »

freebird
freebird
4 years ago

I’ve never carried any significant debt in my life, but I still face that same quandary from the opposite direction. I have ample credit available, should I borrow to invest? If you spotted some high-yielding preferred stock with what you think is an abnormally depressed stock price (like these days let’s say it’s in the oil business for example), would you max out your HELOC and take the punt? That’s not what I would do. I’m glad your bet paid off but I would hesitate to recommend this approach to anyone. In most cases risk-adjusted returns on debt payoff will… Read more »

William Cowie
William Cowie
4 years ago
Reply to  freebird

Let’s be clear: I am not recommending that strategy. No two people are the same. My point was opportunities in the field of your expertise may show up once or twice in your lifetime. At times like that, pragmatism trumps dogmatism. That’s all. 🙂

Syed
Syed
4 years ago

I was literally just thinking about this when I saw the article in my email. I’ve gone back and forth on this, especially in light of my recent new job where I received a significant pay increase. I’ve contemplated just applying my increased income towards my 401k, which would allow me to max it out for the first time in my life, or putting it towards student loan debt. It’s a tough choice, but right now I’m doing both. I’m taking advantage of the tax benefits of a 401k and Roth IRA by maxing them out, while putting what extra… Read more »

Dianecy
Dianecy
4 years ago

Hooray for William Cowie! This is a great article. I am so tired of the kill-the-CC/SL/and most galling, mortgage-debt-before-investing-for-retirement zealots. This article and your subsequent comments illuminate the need for this to be a William Cowie Series. Please discuss why buying individual stocks isn’t the best idea, why buying your company’s stock is risky, and how to maximize returns while minimizing investment risk. Explain why paying off the mortgage instead of saving for the future will only end up costing you more actual dollars, as compound interest can’t start compounding if there’s nothing to compound. Fully explain why the difference… Read more »

Beth
Beth
4 years ago

I think it depends on the debt and the on the investment. When I was paying off my student debt, I used any extra cash 50% towards debt repayment and 50% towards investing. That was more a matter of peace of mind than math though. It felt good to balance building retirement savings with the security that comes from paying of debt. Since I was investing using my RRSP, I could also use the tax refund to further invest/pay off debt. However, if you have high interest credit card debit then the answer should be fairly obvious as to what… Read more »

Marie
Marie
4 years ago

When job security was shaky in my household, we stopped paying ahead on the mortgage and student loans and banked that same amount each month. Once things got better, we took the accumulated money and sent it in to the loan companies. The result was (almost) the same in the end, but we had that cash at the ready for extra security when things looked grim. It definitely helped me sleep better at night.

Scooter
Scooter
4 years ago

It’s a sad fact that debt = wealth for many… I’m 40yrs old and if I hadn’t had access to credit I wouldn’t be in as comfortable position as I am. The ability to borrow a huge mortgage combined with a frugal nature means I now own 60%+ of my primary property in London as well as a larger property in London with 80% equity and a buy to let. While it worked for our generation I can’t recommend the same for my stepson of 28 who will have to get into huge debt with little chance of flexibility. Governments… Read more »

Andy Kizzle
Andy Kizzle
4 years ago

The graph has a major error. That graph says “$5000 annual investment”, when in reality it’s actually a $5000 ONE-TIME investment. Lol.

You’d be looking at north of $2 MILLION if you actually invested $5K annually for 45 years @ 8% ROI. Isn’t that sweet? and that boils down to only $416/month contribution. Nearly anyone can be a MULTI-millionaire for less than the price of a single car payment.

Beth
Beth
4 years ago
Reply to  Andy Kizzle

That would be nice!!! But I find my investments certainly don’t work that way. They have good years and bad years. They don’t compound at a nice even rate like this.

Actually, they don’t compound at all. I find it curious that PF bloggers like to use charts that show exponential growth when stock markets don’t necessarily work that way.

Or am I missing something?

BD
BD
4 years ago
Reply to  Beth

I’d like to know if I’m missing something too. I had invested $10,000 in mutual funds back in 1994. While they have certainly grown in value, they haven’t grown at a steady 8% like the chart suggests. It seems that there have been more “stagnant” or “down” years overall than “up” years, and the average seems more like 5% or less.

Jason
Jason
4 years ago
Reply to  Andy Kizzle

I don’t think you’re reading the chart correctly… the title is Annual Earnings (ie the 8%) of $5000 annual contributions. It’s showing you how much per year you would be making off of the interest alone

Ross Williams
Ross Williams
4 years ago

“And, it almost doesn’t matter what you invest in. Chances are that last year’s earnings will be way higher than any interest you pay on debt in the first year. This is something most people overlook when they make the debt vs. investing interest comparison.” And well they should. This is stupid. If you are investing money you borrowed at a higher interest rate than the return on your investment, there is no “miracle of compounding”. You are losing money every year. Not only will there be no “last year’s earnings”, your principle will have slowly disappeared. There are plenty… Read more »

DonB
DonB
4 years ago

I’m sorry, but this argument is just flat out wrong. You can’t compare the interest in the last year of an investment 45 years in the future to the interest on a debt this year. You have to compare honestly, backdating for the effects of inflation (or guaranteed interest rate as you like). In today’s money, that interest in the last year will look a lot more like the money today, especially if the gain in that last year is one of the years you make less than an “average” 8% yield. If you pay the debt off today, you… Read more »

jestjack
jestjack
4 years ago

I’m torn by this very question…Couple of things…I’m looking to purchase a “new used car” to replace the one DD2 has claimed. I’ve looked around and there are some good deals and I could pay cash without missing any meals. However my credit union is offering 1.9% financing with no junk fees. Well that’s just crazy! In addition as DD2 shops for a cell phone company it has become apparent to me what a “goldmine” AT&T and Verizon have under their control. A modest plan can approach $100 and after speaking to others I hear tales of cell phone bills… Read more »

Kristi @ Femme Frugality
Kristi @ Femme Frugality
4 years ago

You’re right, it is a tough call. I try to do a little bit of both. We are mostly focused on eliminating our debt right now, though.

Emily @ JohnJaneDoe
Emily @ JohnJaneDoe
4 years ago

I think some investment is a good idea, even while trying to aggressively pay down debt. For instance, if you have the opportunity to participate in a 401K with an employer match, it’s probably a better return on your investment to at least get the full match while you put other funds to pay down debt.

Ross Williams
Ross Williams
4 years ago

I think this confuses two different issues. The employer match is effectively a pay increase that goes into your retirement account. Anything you buy before making that match effectively costs you the match in addition to whatever price you pay. It is almost always going to be a better return than paying down any debt. The only reason not to put money into an employer match is that retirement savings are not a priority at all at this point in your life. It is rare that it would be that low a priority. But if you have a business where… Read more »

Sanjeev
Sanjeev
4 years ago

For some reasons, The title “Why investing can be better than repaying debt” does not resonate well. Investing takes time and patience. Educating on investments is very critical since there are so many to choose. I am not against investment, but I firmly believe you have to get to of debt and then invest. It makes NO sense to invest when you have consumer debt like credit cards and others that charge 12%-27%, or you owe money to friends and family money. Personally, Debt is slavery to me. It’s a bondage. Getting out of debt and Staying out of debt… Read more »

Beth
Beth
4 years ago
Reply to  Sanjeev

So would you pay cash for a house then?

Not trying to be snarky — I’m genuinely curious. I think most of us agree credit card debt is bad, but what would happen if people waited until their mortgage was paid off before they started investing? Or if they didn’t buy a home and invested instead?

A mortgage is a pretty scary debt too. The bank can take your house — the place you and your family live — if you don’t pay it.

lmoot
lmoot
4 years ago
Reply to  Beth

You didn’t ask me, but I’ll answer anyhow. “So would you pay cash for a house then?” Yes. “what would happen if people waited until their mortgage was paid off before they started investing?” It depends on what you mean. Passively waiting for a 15 or 30 year mortgage to be paid off is much different than paying down a mortgage in under 10 years. To be clear though, I tend to separate “retirement investing” from “investing”. Others might not, but I do. And I believe retirement saving should always be on a burner, in the background somewhere. “Or if… Read more »

Harmony @ CreatingMyKaleidoscope
Harmony @ CreatingMyKaleidoscope
4 years ago

Our way of investing while focusing on our debt is to continue paying off the mortgage on our rental property. Although, it’s hard to argue with that chart. I receive automatic 401K contributions from my employer, but perhaps I will use my bonus this year to augment that number a bit.

Diancey
Diancey
4 years ago

Are you contributing enough to get the full match? Some employers do not allow lump sum catch-ups, so make sure yours isn’t one of them. The fact that you’re prepaying the mortgage on the rental property is a red flag that you don’t fully understand how leverage works. I’m guessing you’re doing your own taxes, too. A consult with a CPA might help you discover just how many ways you are hobbling your future self.

lmoot
lmoot
4 years ago
Reply to  Diancey

I wouldn’t assume that the decision to prepay a mortgage means ignorance about leveraging. There are logical reasons to prepay debt and one of them is protection against vulnerability. Also, leveraging can backfire if you over leverage to the point that no one will lend you money anymore due to a high DTI ratio, which could freeze or slow down additional investment opportunities.

lmoot
lmoot
4 years ago
Reply to  lmoot

Oh and there are much worse ways to “hobble” ones finances and I would hardly call paying off debt one of them. Especially when investment property is involved, one can actually out perform stocks with real estate. It’s one thing to say you believe stocks are a better investment, but to actually equate paying off debt to being fiscally irresponsible is reaching just a tad.

Harmony @ CreatingMyKaleidoscope
Harmony @ CreatingMyKaleidoscope
4 years ago
Reply to  Diancey

We’ve made plenty of money mistakes and I will be the first to admit that we don’t have it all figured out just yet. That being said, I do receive the full match from my employer and we don’t do our own taxes. The rental property was our first home which we kept as a future source of income.

Diancey
Diancey
4 years ago

First of all, Imoot, you are an advanced student, so this advice was not directed at you. This quote makes it sound as if Harmony is not fully contributing to their 401K. Many employers do not match catch-up contributions, so an “augmentation” may not result the full match. “I receive automatic 401K contributions from my employer, but perhaps I will use my bonus this year to augment that number a bit.” I see that Harmony has since offered more information, which is helpful. If they are contributing to get the full match, adding more may not be the best option,… Read more »

Joe M
Joe M
4 years ago

Debt is real, investments are speculative. Repay debt first.

Ross Williams
Ross Williams
4 years ago
Reply to  Joe M

I think this makes a very important point. Where do you find an investment that GUARANTEES a return equal to the interest you are paying on debt? Most of investment alternatives to paying down debt have a lot more risk to them, you may get a higher return but you may also lose money instead.

Andrea
Andrea
4 years ago

The title of the graph is misleading. “The Annual Earnings of an Annual $5000 Investment” assumes you are putting in $5000 each year (“$5000 annual investment”). Which with no interest would be $225,000 after putting in $5000 annually. In this scenario, the graph looks like your investment actually LOST money. In the original post the chart showed the earnings of just the interest on a ONE TIME investment of $5000 over 45 years. The title accurately reflected the data in the original post. I think that is what was meant here too but it might be helpful to clarify that… Read more »

Andrew & Vee
Andrew & Vee
4 years ago

My wife and I have paid off all of our student loans (almost 100k) and half of our house (over 65,000) over the past three years. I don’t regret it one bit. We were however maxing her 401k and have an emergency fund. We just started investing again into a taxable account. For us it’s all about owning what you have. Investing can be a gamble, but so is life. I only want to gamble from here on out from a position of power-that position…being debt free. It also helps with peace of mind. A nice read here. Andrew& Vee… Read more »

Pam G
Pam G
4 years ago

Great article. Thank you William!

Marsali
Marsali
4 years ago

I’d be interested to hear peoples’ thoughts on investing student loan money. My husband is currently doing a Masters program, about to start his Ph.D. So far, we’ve only had to take out a small student loan to cover the last portion of tuition. However, it looks likely that we’ll need to take out student loans during the Ph.D., to cover some living costs. We’ll do everything that we can to limit them, but it may be inevitable. The thought I keep having is, “Do we save and invest some of the loan money (long-term for retirement, short-term for a… Read more »

Beth
Beth
4 years ago
Reply to  Marsali

I think this article is meant for people who can pay for their basic needs and wants and have cash left over besides. It sounds like you and your husband aren’t there yet if you have to take out more student loans to cover living costs. No judgement — you’re just in a different stage of your financial journey. IMHO, it’s “extra” in terms of cash flow but you’ll still be incurring debt so it’s not surplus, really. I was there and what I did was hold onto the cash in a savings account (or other vehicle of your choice… Read more »

Ross Williams
Ross Williams
4 years ago
Reply to  Marsali

I agree with Beth. Maintain as much flexibility as possible when you are starting out. Obviously the interest you are paying is an important factor in the decision. But student loans are usually cheap compared to credit cards and the interest is deductible as an adjustment to income if you use the money for education expenses. That means you can deduct it even if you don’t itemize.

Diva
Diva
4 years ago
Reply to  Marsali

I wanted to chime in with my agreement with Beth and Ross. Please do not invest your student loans. If you have that kind of surplus of loan money, I would say don’t borrow it in the first place, or, as Beth said, hold it as an emergency fund. I just paid off my student loans after 20 years and I can’t tell you how freeing it was. There were so many things I couldn’t do because I had this debt (it wasn’t even very high, $40,000) that my other debt-free friends never had to worry about. If you borrow… Read more »

Diva
Diva
4 years ago
Reply to  Marsali

I would not invest your student loans. If you have that kind of extra I would advise you not to borrow the money in the first place, or as Beth suggests, keep the money as an emergency fund and then pay it back when you have more cushion. Side note: When I was in school, a wonderful banker had me break up my loan into monthly portions, and then each portion was set into a CD that would come due every month. That way I stayed on budget and, while the interest was low, came out of it with some… Read more »

Diva
Diva
4 years ago

I don’t think it’s better to invest than to get rid of one’s debt. I agree with those folks who suggest that one can pay off debt at the same time as they contribute to their company match 401K or Roth IRA, and perhaps another side venue. But debt is always with you until you pay it off, even in bankruptcy, if you’re talking about student loans. It’s an albatross around your neck. So even if you happen to gain in some investment, you’re still dragged down by your debt. I read the blog by Mr. Money Moustache a while… Read more »

chinni
chinni
4 years ago

I think sometime investment is a good idea, even while trying to aggressively pay down debt.

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