If there’s any question more common in the personal finance world, it’s this one: Should I pay off debt or save that money instead?
I love this question, because it’s addressing a financial topic that I wish were on the forefront of more minds. Paying off debt and saving are two great ways to utilize our money that we should all be thinking more about. Your situation isn’t as cheery if you’re having to decide between paying off debt, saving, purchasing a new sports car, or buying a bigger home you can’t afford.
While the decision of paying off debt versus investing is a little more art than science, there are some guidelines most people should try to follow when making the decision.
Earning a “Guaranteed Return” on Your Investment
Paying off debt earlier represents a “guaranteed return” on your money. What does that actually mean?
This means the money you would be paying in interest each year is being avoided. For example, simply making your mortgage payment each month will do nothing to save you interest over the length of your loan. However, making an extra payment every few months can substantially decrease the interest you’ll pay over time.
In essence, rather than paying interest, you’re earning it. "A penny saved is a penny earned” as Benjamin Franklin quipped.
This sort of guaranteed return is unheard of in investing. The ups and downs of the stock market can’t guarantee anything. We can look at how the stock market’s historical performance, but that’s never a guarantee of how it will do in the future. Even more conservative investments--like bonds or an interest-bearing savings account--don’t have a guaranteed return. Paying off your debt does.
The stock market never provides a guaranteed return. Paying off debt does.
When is a “Guaranteed Return” Too Low?
Not every guaranteed return is worth pursuing though. You’ve probably heard this argument before. Back when mortgage rates were around 3 or 3.5% the logic for many was that rather than making extra mortgage payments, you should instead invest your money in the stock market where the returns are historically higher--closer to 8%.
The economics of this argument tend to make sense if you’re willing to accept the risk of the market’s ups and downs. The argument is even more compelling if the option is to pay back a loan of, say, 2% rather than invest. It’s usually makes less sense to pay off debt if the interest rate is lower.
Paying Off Debt Can Bring Peace of Mind
However I know many people who don’t care how low their mortgage rate is or whether their mortgage interest is deductible--they want that debt gone! All economics aside, I have tremendous respect for these individuals and families.
Kellie and I have this same mindset. We try to find opportunities to make an extra payments towards our mortgage when possible. We know it probably hasn’t made much economic sense, but the peace of mind that comes with saving interest down the road feels amazing.
Two Debts You Should Payoff Like Crazy
While there is some gray area when it comes to paying down lower interest debts, there are some debts that I believe should be paid off before most saving takes place. This is because the typical interest paid on these types of debt matches or even exceeds even the rosiest projections of the stock market’s performance over time.
Credit Card Debt - The average credit card interest rate is 15%. You read that right. That’s nearly double the expected long-term return of the stock market, yet millions of American families are paying it every year. And it’s usually for “stuff” we bought with a credit card. Before you do any type of long-term saving (other than an emergency fund), pay off your credit cards.
Student Loan Debt - Of my clients with student debt, most loans tend to carry an interest rate of 6% to 7%. While this rate is substantially lower than credit cards, it’s still high. Private loans (unsubsidized by the federal government) tend to be even higher. While student loan interest may be tax deductible, it’s usually not worth carrying this “ball and chain” around for long. Give yourself that “guaranteed return” and pay them off.
Prioritizing Debt Payoff and Savings
Clearly all debts are not created equal when it comes to repayment. And certainly every family should be putting some money away for future needs, like retirement. But how do you prioritize? Following is one approach you could consider.
- Set up an emergency fund before paying off any debts - A few thousand dollars is a good start, but work toward 3 to 6 months of your essential household expenses.
- Pay off high interest rate debts - I’ve beat this dead horse long enough. Get rid of credit card debt and student loan debt quickly.
- Save toward future goals with investments paying a higher average rate of return - Once an emergency fund is set up and high interest debt is paid off, start your long-term savings. One caveat: If you earn a company match through an employer retirement plan, like a 401k, one could justify earning this full match before the high interest rate debts are paid off. It’s free money that should not be passed up.
- Pay off lower interest rate debts - Most mortgages and auto loans fall into this category, though interest rates are creeping up.
As stated earlier, this is a personal choice and unique to your feelings and comfort level with debt. The main point is that paying interest that exceeds what you can earn in the stock market doesn’t make sense. Get a small amount of savings built up for emergencies and go after those high interest debts as hard as you can, then think about saving. You’ll be glad you did.