When To Focus On Investing Vs Paying Down Debt

Should I invest or pay down debt?  It’s an old debate with no easy answer. 

But where you put your money makes a huge difference in your financial life.  Five extra years of compound gains on an investment adds up to huge dollars later in life.  At the same time, five more years of debt makes that car, student loan, or medical bill cost a lot more than you thought you were paying. 

There are mathematical answers.  Philosophical answers.  And psychological answers. 

It depends on the type of debt.  And the type of investment. 

I have done my best to boil it down to some simple rules.  If you follow them, you should arrive at a good answer, and it will be hard for you to go wrong. 

Here are my general rules for whether you should invest or pay down debt. 

Bad debt 

First, let’s consider all types of “bad debt”.  That is, any type of debt that isn’t tied to an appreciating asset, such as: 

• Credit cards 
• Student loans 
• Vehicles 
• Medical bills 
• Personal loans 
• Payday loans 

Student loans are arguably “good debt” when they came with a valuable degree and weren’t used as an excuse to party for 4 years.  But they’re a type of consumer debt that can reach very high levels.  And they’re a major problem in America today.  So I’ll call them bad debt for the rules I’m about to give you. 

Rule 1: Pay off high interest debt as soon as possible 

The first thing you’re going to ask is “what’s considered a high interest?”  

My rule of thumb is that anything over 5% is a high interest rate. 

Paying it off gives you a guaranteed, tax-free return that easily beats long-term inflation of ~3%.  That’s hard to beat some years in the stock market.  And it’s right around the historical return of bonds.  But as we saw in 2022, bond prices can go down too! 

So I’ll take a 5% risk-free, tax-free return.  And I’ll be happy to get rid of some debt at the same time! 

Rule 2: Only pay off low interest debt quickly if you’re losing sleep at night 

This is where Dave Ramsey followers—as I was for years—might jump out of their seat.  And those who strictly look at the math will applaud. 

Below 5% interest, I won’t force you to pay down your debt faster than your normal payment terms.  That assumes that you have at least 10 years before you’re planning to retire and you’re aggressively investing in assets like stocks and real estate.  The odds are in your favor. 

But as Rule 2 says, you can’t be losing sleep over it.  If you’re the type of person, like I was, who worries about owing money to other people at anything over 3%, then go ahead and pay it off!  I’m not stopping you there either. 

There’s a lot to be said about controlling your emotions and having peace of mind.  It isn’t worth an extra 3-5% annual investment return if you’re harming your mental and physical health to get it! 

One last note.  Just because I’m letting you invest instead of paying off your 4% car loan ASAP doesn’t mean I want you to go out and get more debt!  Your goal should be to pay off the debt you got yourself into and stay out. 

Good debt 

Now let’s look at good debt, which is tied to an appreciating asset of some type.

Business debt is really a separate issue because it depends on the type of business you own, what the debt is being used for, and how it’s tied to the profits that you generate.  So I will leave that for another discussion. 

Investment debt, used for leverage on stocks and bonds, is not something I would ever tell you to use. Although it’s loosely tied to an asset, and many consider it good debt, it’s riskier than wisely used business or real estate debt. So if you have investment debt, we’ll throw it in the bad debt category and go back to Rules 1 and 2. 

Mortgage debt, including mortgages on rental properties that you personally own, are the most common type of good debt.  I would recommend using the following rules for your mortgages: 

Rule 3: Pay off high interest mortgage debt after you’re maxing out every tax advantaged account and still have money left 

I realize that mortgage rates went from under 3% to over 6% in 2022.  So you may be looking at a high interest mortgage now. 

And you’re probably reading this article because you have extra income to work with.  But if you’re wondering whether a mortgage is affordable for you, read Spending Money Wisely for some good rules on home (and vehicle) affordability. 

Now, Rule 3 says that you should first max out your tax advantaged accounts.  Read Put Your Savings in These Accounts First for the order that I recommend following.  If you still have room in an HSA, IRA, 401k, 529, or 457, keep going! 

But before you start putting money in a taxable brokerage or high yield savings account—beyond an emergency fund—you should start paying off that high interest mortgage debt and locking in another risk-free return. 

Rule 4: Don’t pay down a low interest mortgage unless you can pay it off and be financially free 

If you were lucky enough to get a 2-3% mortgage in 2021 or 2022, you’re in great shape! There’s no hurry to pay off a fixed rate that low. 

But I didn’t go back into debt to get that rate, because I’m financially free. And having zero debt makes financial life easy! 

If you can pay off your mortgage and reach Financial Independence (FI), do it. 

If you’re still on the Ascent to FI, though, you have a bigger priority: to build wealth. 

Pile all the extra money you can into investments instead.  Then, one day you’ll realize that the market is at an all-time high, and you could sell some stocks in a non-retirement account to pay off your mortgage! 

That’s when you have a fun decision to make. Let those investments ride? Or simplify and stabilize your finances by getting rid of your last debt? 

Just make sure you understand the tax consequences of the stocks that you sell. And celebrate that you made so much money that you get to pay taxes. It’s a good problem to have. 

This move won’t make you build wealth faster than keeping everything in stocks. But it will give you peace and help you realize that you have enough. Not every decision is a financial one. 

Paying off your mortgage and claiming Financial Independence is a huge psychological win. It de-risks your life. And you can feel an emotional weight lifted off your shoulders. No more payments. Life suddenly costs less. 

This should be the goal for most people. 

Summary 

Deciding to invest or pay down debt is a financial, philosophical, and psychological decision.  

Follow these 4 rules to balance your money and your emotions: 

1. Pay off high interest “bad” debt ASAP 
2. Only pay off low interest “bad” debt quickly if you’re losing sleep at night 
3. Pay off high interest mortgage debt after you’re maxing out every tax advantaged account and still have money left 
4. Don’t pay down a low interest mortgage unless you can pay it off and be financially free 

This article was originally published on PathwayToFI.com and appears here with permission.