You are probably working on your financial independence., why else are you here? Hopefully, you have some leftover money in your budget and are now wondering. Should I pay off existing debt or invest my money in the stock market or real estate?
Of course, many people will declare that you should pay off debt first, but not all debt is bad. There are many examples where taking on some debt is good because it enables you to do things you otherwise would not have done, such as go to university or buy a house.
Other people will say that investing is the only option while walking a fine line between paying minimum debt repayments and going bankrupt.
Both camps have valid points here, so the decision is not always as simple as it could be. Which solution is right for you? Let’s take a look at a couple of different viewpoints.
Dave Ramsey is the author of “Total Money Makeover.” He is firmly in the no-debt camp. He advocates paying down debt aggressively using the debt snowball method where you tackle low-balance debt first, then move to the next smallest balance until you have paid off all non-mortgage debt.
As you eliminate a small debt, funds are freed up to use the next smallest debt. As time passes, while paying the minimum on all other debts, you will eventually have destroyed all your smaller loans and credit cards and are set to concentrate on the final, biggest loan.
Ramsey is very good at motivating people to get out of debt. What he does is fantastic, but it’s not for everyone. For people who have difficulties managing their money, Ramsey’s advice is solid and will help you get the ground back under your feet.
Sam – Financial Samurai
Sam from Financial Samurai came up with his system regarding the question of debt vs investments. It is called FS-DAIR, or Financial Samurai’s Debt And Investment Ratio. It is a more scalable approach to paying down debt than the debt snowball method.
In Sam’s system, you pay down loans in order of interest rate, highest first. You multiply the interest rate by 10 to find your allocation of money towards that debt. If you have a 5% loan, you’ll allocate 50% of your monthly savings amount towards that debt and invest the other 50%.
All loans over 10% are toxic and should be paid off as soon as possible. They warrant a 100% allocation. If you have multiple loans with varying interest rates, the system is easy. Say you have a 16% credit card, a 9% personal loan, and a 2% student loan. You will then allocate every euro you can find towards paying down the credit card. Once that loan is gone, you start using 90% of your monthly savings towards the personal loan while investing 10%. As soon as that one is gone, you bump up your investments to 80% and use the remaining 20% to pay off your student loans early.
The Good, Bad, and Ugly
In principle, we like what Ramsey’s method achieves. For people who have had out-of-control debts beginning to spiral, the debt snowball is a great way to help bring these back under their grasp. But if your debts are manageable, we prefer the FD-DAIR approach. Yes, your debt will last longer, but you begin to grow some investments now, which have the capability of matching the negative interest of your debts, if not exceeding them. And once your debts are gone, you will still have your investments for the rest of your life.
We do think there’s good debt. Low-interest funds that are reallocated to investments instead can be profitable. Paying off good debt is not something one should aim for when you’re young.
When the debt is high interest or generally considered “bad” (such as short-term consumer loans), put everything you have towards paying them down. If the debt is low interest, such as a long-term mortgage, we would keep it and invest.
In our opinion, it is considerably better to have a sizeable investment portfolio without worrying over ‘good’ low-interest loans.
So, Pay Off Debt or Invest?
While we like Sam’s FS-DAIR system for its formula-based but straightforward solution, we do think that it should be capped both on the upper and the lower end of the spectrum.
Let’s start with the lower end of the interest rate spectrum. We don’t feel excited about paying 20% of our monthly savings towards a 2% mortgage. Especially not when young. This is the time to invest heavily in yourself and your future, and a 2% mortgage can wait to be paid off in its own sweet time.
At the higher end, we don’t agree that an 8 or 9% interest rate personal loan should be paid back in any way other than at maximum speed. A good average stock market return is around 10% per year for the last century, barely anything more than that loan’s interest rate – so we’d want to pay those down first.
So here is our slightly modified version of the system.
Introducing My New System
Let us introduce to you the Fire The Boss system. The FTB system follows Financial Samurai’s general glide path but introduces a cap to the lower end of the spectrum and arrives at a 100% allocation sooner than you would with FS-DAIR.
So when you want to decide to pay off debt or invest, take a look at the table below.
|Interest %||Allocation %|
The formula to find your debt allocation is 20 x (interest rate – 3%).
Implementing the System
So now you know what we suggest that you do when paying off debt and investing. Depending on the interest rates on your debt, you will either invest more and focus less on debt or vice versa. I’m a big believer in investing big, but when you’re under the stress of a lot of high-cost debt, it is better to pay this off early.
We modeled this system against our own beliefs, and it is in no way financial advice. Please always do your own research and make your own decisions.
In practice, this system means that you would not pay off any additional funds towards a mortgage or low-interest loans below 3%.
If you want to pay off debt, what strategy do you use? The Snowball or the Avalanche?
Do you pay off debt, or invest, or both? Let me know in the comments below.