A common financial topic begging for answers is whether to pay down debt or invest. Over much of the internet, it is encouraged to pay down your high interest debt before investing in a Roth IRA or putting money into a 401(k) above the employer match.
The difficulty has always been in defining what, exactly, high interest means!
The true break-even solution is when the returns you make on your investment is equal to the interest rate on the debt. In this scenario, it is effectively a wash... But what number should you use for determining your investments? What about inflation? What about the psychology of paying down debts? What about the specter of uncertainty? These topics (and more!) will all be discussed in this article.
Why you should use inflation-unadjusted numbers to choose to pay down debt or invest
Inflation is a net positive for debtors/liabilities. If you are in debt $103,000 and the inflation rate is 3%, by next year your debt will have decreased to $100,000 in real terms. The opposite is true for savers/assets. An asset worth $103,000 will then be worth the equivalent of today's $100,000 after a year of 3% inflation. When you look at the APR on your debt, however, that is expressed in today’s dollars. Thus, it does not make sense to compare APY with inflation-adjusted returns.
Let me attempt an example to show you “inflation-adjusted APY” and why it’s easier to just use non-inflation adjusted numbers. If you have a liability of $100,000 @ 3% APY, you owe $3,000 in interest that year. Let’s say inflation is also at 3%. You pay $3,000 in interest but your new debt is only worth $97,087. Your “effective APY” is essentially 0.09%. Your liability is decreasing in worth (a positive!) at the same rate as you are paying interest. This is exactly true (in opposite) for assets. For the rest of this article, I will thus be talking in inflation-unadjusted terms.
What is the right number?
This is a theoretical question. For each individual, it will depend on their risk tolerance, asset allocation and goals with the invested money. I, for example, am heavily invested in stocks. Thus, using our handy S&P 500 calculator, I can show that for the past twenty years, the S&P 500 has returned roughly 9.6%. This is the number that I will be using for determining whether I should pay down debt or not. Is this too ambitious? Read ahead to the section on value in certainty.
Psychology of paying down debts
"Pay yourself first."
This is one of the core mantras of personal finance everywhere. The theory is that you are unable to spend what you do not have. By paying yourself first, you become psychologically adjusted to the lower amount of money and then are able to reign in your spending to the new amount.
The same can be said for paying off large chunks of debt. If you have $1,000 extra sitting in your checking account, you may be tempted to spend it instead of invest it. By paying the debt immediately, it forces saving in a way that the alternative (investing in a 401k, Roth IRA, etc.) does not provide. For some, it may be a choice of saving $800 at 9.6% or paying down $1,000 at 5%. In this scenario, it is arguably better to pay down the larger amount, despite the trade-off in longer-term payoffs.
It is difficult to say how true this is for each person without knowing their individual personal finance discipline. I imagine, however, that the difference is greater than $0 for every single individual whether they like to think they are perfectly disciplined or not.
Value in Certainty
All of the argument so far has been using a fixed number to compare debt paydown (APR) with a fixed number for investment return (the aforementioned 9.6%). One of the key concerns that arises when using this is what value lies in the certainty of a return on debt and the uncertainty in looking at future returns? This risk spread exists in all forms of markets and is the underpinning to the insurance market (negative expected value decision that minimizes future fluctuations in cash flows). If I used a different timeframe such as the past ten instead of twenty, years, I would have only received 7.2% as my number. Clearly, there is some uncertainty in the number I should use for paying APR.
What price do you place on this certainty though?
What number do you use to determine whether to pay down debt or invest the difference?
Is there any good place to find low cost leverage?