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?
Different Opinions
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
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.
I even took out an additional mortgage to invest!
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.
Your investor policy statement should include whether you want to eliminate debt or invest instead.
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 % |
|---|---|
| 3% | 0% |
| 3.5% | 10% |
| 4% | 20% |
| 4.5% | 30% |
| 5% | 40% |
| 5.5% | 50% |
| 6% | 60% |
| 6.5% | 70% |
| 7% | 80% |
| 7.5% | 90% |
| 8% | 100% |
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.
10 thoughts on “Should I Pay Off Debt or Invest?”
Interestingly, my opinion on this topic changes over time depending where I am in my life’s journey.
Initially, when just buying my first home, it felt like a huge commitment. And I totally wanted to get rid of it asap. I considered this an unsustainable emergency. Yuck!
It made me realise how much my freedom is worth to me – I put it above being efficient.
So, I took up a mortage that would require me to linearly pay it off and I took a variable rate – why not, I was going pay it off fast anyways – and that way I could keep my options open to pay it off even faster without penalty.
Then some months into it, I changed my mind a little, if I pay it off that agressively, life is no fun.. and this is going to take a while.
My freedom to me also means being relatively free from decisions made by past me, atleast ones that future me might not approve of.
So, instead I kept paying off linearly and started investing whatever felt ok. I can still one day decide to pay off the mortgage and I could do that even faster, if the market is doing well at that time.
For a while it was fun to watch my mortage debt get destroyed every month, and the monthly interest go lower and lower both due the lower principal as well as lowering interest rate due to the variable rate.
But that got boring and then wore off when instead I got annoyed that all that money is going into the bricks.. not even thinking about the potential value of my house that was stuck in there due to appreciation.
So, I think it’s really cool that you’ve pulled money out of your house here in the netherlands, it’s something that seems more commonplace in the US. I considered that before but never actually dived deeper into it. The market is excellent to refinance for that at the moment.
Paula Pant at Afford Anything makes it seem common practice as a rental realestate investor to occasionally do a cash-out refinance to keep it at a 50% allocation, after some period of inflation. By the way, I highly reccommend her podcast as youy’re intestested in rental income. She’s recently put a course out to get started as a realestate investor. it’s geared to the US market and doesn’t consider out of country investors (but it does consider out of state investors which sort of is the same thing).
I might even consider a lower allocation than 50%, considering how relatively less risky the dutch housing market is in comparison with the US. Especially if you’re also the occupant of the home. Ideally, we should be able to play with this depending on where we are in life. Unfortanately, it’s hard to get a good mortgage past 75, and I’m planning to get way older than that.
I’m still unclear about the end game scenario, there is no point in using the 4% safe withrawal rate to determine what you need have in stockmarket in order to pay off the mortgage and the interest on it, if you plan on paying it off. With the mortgage being a fixed numbe, and the interest rate can be fixed as well, paying it off does not require considering inflation. So why not simply pay interest only or set something aside that will accumulate to paying off the mortgage to a ratio that’s acceptable.
Great article. What is your opinion on student loan debt? Do you consider this to be more like a mortgage-kind of a debt or should you try to pay it off as quickly as possible?
Depends on the interest rate and more. If you want to buy a home in the near future and need the maximum mortgage, sometimes paying off even a low interest student loan makes sense. But as always, I’m not a financial adviser so do your own research.
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I find when talking to people about debt(mortgage) vs. investing, that their attitude tends to lean towards paying off your debt(mortgage) as fast as you possibly can – but it varies a little, the younger they are.
People in their 40s or 50s still remember when the interest rate was 20%.
I’m 35, and my first mortage was around 5% interest rate. It’s only been going down from there, and I’m currently paying 0.5% (flex-mortage, 3-year fixed interest intervals).
Most of my friends have fixed 3%+ mortgages, and I understand why they would want to pay off their mortgage fast, rather than use the excess cash to invest. The big question here is, where the interest rate is going to be in 3-5 years. Nobody knows.
If you’re sensible, you’ll expect the interest to once again climb back towards 5%. If you’re a risk taker, you won’t ever expect it to reach 5% again. I’m somewhere in between.
I’m currently leveraging my mortgage payments (to use the money to invest instead), and I only pay off my mortgage 3/4 of the year. Next year I plan to lower it to 1/2. I owe about 75% of what my house is worth. Ideally, I would like to get it below 50%, and then stop paying it off altogether (convert to an interest-only loan). Perhaps that is risky, I don’t know. It all depends on where the interest rates goes from here I suppose. Considering the worlds massive debt, I honestly find it difficult to believe that the interest levels should double from their current levels – but who knows. It all depends, how much risk you’re willing to take. As my investment portfolio grows, my risk exposure towards the interest rate will automatically drop. Once my portfolio is worth the same amount as I owe in my house (mortgage-neutral), I really don’t see a reason to pay it off at all (as long as my interest rate remain below the inflation level…).
I think you need to also factor in your equity (somehow) in your system. – But I’m only thinking in terms of mortgages – I’ve never had any other kind of debt, and I find it hard to understand why people would borrow money to buy depreceating assets at outrageous interest rate levels.
This should be a thumb rule in your system! *IF YOU ONE DAY FIND YOURSELF LOOKING TO BUY AN ITEM, AND THE INTEREST RATE EXCEEDS x% – DON’T BUY THE ITEM! YOU DON’T NEED IT! :P
Love the new site and redesign. Cool to see that you also switched to English.
I think that one should not have any debts besides a mortgage. Eliminate debt, build emergency and start investing. That would be my order of business.
Thanks Mr! I generally agree with you on that strategy.
I think this question is easier to understand when you take “consumption” into account. What’s better? Investing, consumption or paying off your debt? If you invest, then normally you get more money in return (on the long run). When you consume, you don’t get your money back and when you pay off your debts, you can’t use that money for new investing or new consumption.
Hi Fred, thanks for your reply! I disagree that consumption should be taken into consideration. Because if you choose to consume instead of save/invest/pay loans, your balance sheet actually declines. Your balance sheet does not decline when saving/investing/paying off loans. So the actual question is to consume or not. When you don’t consume then the question to invest or pay off loans comes into play.
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