Here's the latest post in the Rockstar Finance Money Match-Up series where two money bloggers argue opposite sides of an issue. Today's issue is about what to do with excess funds -- should you use them to pay off debt (even your mortgage) or invest them instead? The two bloggers discussing this issue are Laurie from The Three Year Experiment who favors paying off debt and Moose from Making Sense of Life who believes it's better to invest. We'll begin with their opening statements, then get on to the issues...
Laurie: Why You Should Pay Off Your Debt, Every Time
Pay off your debt, or invest the difference? There are so many arguments on both sides. In the end, the vast majority of people are better off thinking about their behavior. Here’s why I’m convinced that you should pay off all your debt, even your mortgage, as quickly as you can.
Moose: Consider Investing Instead of Paying Down Low-Interest Rate Debt
Automation makes hedging against your worst impulses easier than ever. The math behind compounding interest makes capital efficiency paramount, especially if you're younger. I advocate investing over paying down low-interest rate debt.
The Discount Rate
Laurie: We’ve all heard it. Sure, mathematically, it makes sense to keep your mortgage at 4.5% and invest the money you’d otherwise spend paying it off in the stock market. There’s no arguing with the mathematics. Here’s the problem with that argument: there are human beings on the other side. As much as we’d like to think we’ll take the money we’d otherwise use to pay off our mortgage early and invest it in the stock market, the truth is, many of us might, despite the best intentions, fritter it away on eating out and “emergency” home remodels. Once we’ve paid our debts off, they’re paid. We dramatically decrease our cost of living and stop paying interest, a massive destroyer of wealth. Moose: I understand that maintaining the level of discipline to consistently invest instead of paying off debt is difficult. That’s why I automate the process. With automation, you don’t even see the “extra” money, and it goes to work for you without any additional time and effort required from you. Once you automate your saving and investing, you don’t have to worry about wasting the money you could otherwise use to pay down debt. Even if the Investment Hurdle Rate (“IHR”) that dictates that I don’t need to pay off a debt early, I typically kick in a little extra to the payment every month anyway. I still invest the bulk of my free cash flow, but I like to both invest and accelerate debt payments along the way. This way you get the benefits of both.
Having a Goal
Laurie: Being laser focused on the goal of paying off debt does something to your psyche. Focus is powerful. When my husband and I were paying off our consumer debt a few years ago, we came up with ingenious ways to earn more money (selling stuff we didn’t need anymore, marketing online), thereby paying the debt off faster than we would have without such a goal. Yes, we stopped investing during those years. But in the years since paying off that debt, we’ve increased our net worth by leaps and bounds, using the same principals of artificial scarcity we adopted during our debt payoff. Moose: This aspect of finance depends entirely on you and your mentality. If, like Laurie, you are most motivated by seeing $0 next to your old debts, you should consider focusing on paying down debt. If you’re like me though, you get more of a “kick” from seeing the value of your portfolio and net worth grow. I’m more motivated by adding to the positive side of the net worth balance sheet than subtracting from the negative. The IHR is a decent estimate of what your investments should return in the long-term (and most of Wall Street uses this figure). More often than not, you’ll see your net worth increase more quickly by investing instead of paying down low-interest debt. Big disclaimer: this only applies to low-interest debt! If I had any interest rates over the IHR, or even somewhat close to it, I would prioritize paying that debt off ASAP above anything else.
Laurie: I’m a big fan of behavioral economics. A field of economics developed mainly by Amos Tversky and Daniel Kahneman in the 1970s, Behavioral Economics studies why humans do irrational things. Why do we put more money into an already sunk cost? (It’s the reason I put $9000 into a dying hunk of junk in one year… “if I can just get this repair done it’ll make the $5000 I already spent ‘worth it’”). Why do we spend more on a credit card than we would with cash (separating ourselves from our money makes it hurt less when we spend)? Human beings make 95% of our decisions using mental shortcuts or rules of thumb. We are irrational beings. Our brains have developed to do some irrational things when it comes to money. It’s why so many people have been successful paying off debt using the Dave Ramsey method. Because it taps into behavioral changes, rather than a debt-repayment method that makes the most mathematical sense. Maybe you have gobs of self-control. Perhaps you wake up every day at 4:30 am, work out for 2 hours, go to work, eat healthy food, spend several hours in the evenings being fully present with your family, go to bed precisely at 8 pm, and wake up and do it all over again the next day. But that’s not me. That’s not most of us. Most of us struggle to match our behavior with our goals. We struggle to do what makes the most sense economically. Heck, it’s why we have debt in the first place. We should pay our debt off and never allow ourselves to get into debt again because that way, we give ourselves the best chance to change our behavior. In the long run, even if we miss out on investing in retirement for a few years, the long-term behavioral changes from paying off debt will counteract that investment loss. Moose: I do have a gob of self-control, but I hedge myself by automating my investments, as I mentioned earlier. Paying off my high-interest debt gave me the grit and experience to never allow myself to enter that situation again. The younger you are, the more the effect compounding has on your net worth. This concept is perfectly illustrated in my Money Multiple https://www.msolife.com/money-multiple/ calculation. So, if you’re already close to retirement age, sure, postponing investing may not have a humongous effect on your net worth. However, if you’re in that crucial 25-35 age range, those extra years of compounding make a monumental difference. This is the primary reason I decided to develop the IHR; so I could draw a line in the sand and clearly delineate what absolutely must be paid off now vs. what I can take my time on.
Laurie: When you pay off your debt, you’re no longer a debtor. You’re no longer a victim. You are empowered. You’re one of the few Americans who doesn’t owe someone else something. That feeling of empowerment then leads to newfound feelings of self-worth, pride, and belief in your ability to run your life well. There’s something so freeing about not having payments. When we paid off our car loans, it felt amazing. We get to keep that money every month and send it to our investment accounts. We are in control. So stop worrying about the mathematics, and get rid of your payments. You’ll thank me later. :) Moose: I’m all for empowerment. Paying off a debt is a great feeling. The dopamine hit you get from sending in that final payment is hard to compare to anything else. Except seeing your portfolio steadily grow. Not having payments is crucial and immediately decreases how much you need in your emergency fund and hastens your early retirement. My argument isn’t for ignoring all debt but emphasizing investing once you’re only saddled with low-interest debt. Let’s say I have an extra $100 per month of cash flow. Depending on how far below the IHR my interest rates are, how I feel about debt, and how close I am to the finish line (financial independence), I’ll dedicate a different percentage of that $100 to debt. Before my mini-retirement, I invested $90 and used $10 to pay down my debt more quickly.
Ultimately, Laurie and Moose both have valid points. The advice they each offer is sound. However, they offer different paths to the same end goal of financial independence precisely because we’re not all the same. We all have a different tolerance for risk and different life goals, as well as different amounts of self-discipline with our finances. Personal finance is, as the name implies, extremely personal. Do what works best for your situation! If you’d like to eradicate all your debt now, let Laurie be your guide. If you still have some low-interest rate debt and want to invest, consider what Moose is saying. You know yourself better than anyone else; the important thing is to be consistent and stick to a plan once ------------------------------------------------------------------ So, those are the two sides of the issue. What do you think?