It’s an age-old question: should you pay off debt or save/invest first? At the end of last week, I read an interesting guest post about student loans and asset allocation written by The Physician Philosopher (“TPP”) for Physician on Fire‘s (“PoF”) blog. In it, TPP talked about the diversification his student loans provide for his investment portfolio because of the guaranteed return he gets as he pays them off. He mentioned that he and his wife max all available retirement accounts before paying extra on his loans. He plans to be finished paying them off within two years after he finishes his fellowship training.
The argument for aggressively investing while paying off debt
TPP and I got into a heated debate quite civil discussion in the comments section about whether it’s better to pay off loans before investing or to invest as much as possible while paying off debt. My understanding of his argument is (1) your savings rate is the strongest determining factor in your ability to reach financial independence/early retirement quickly, and (2) as high-income earners, we can afford to do both. He’s not alone. Others in the personal finance community also argue for investing as much as possible while paying off debt. Josh Holt from The Biglaw Investor makes a similar argument (and is actually part of the reason we were maxing our accounts up until last year). I get it, especially if you’ve refinanced your loans to a lower interest rate. Why pour money into paying down a loan at 3% interest when you could make 8-10% if you invested it instead? Basic math tells us that 8 or 10 is greater than 3.
Why that argument doesn’t work
This is about more than math. It’s also about risk. If you turn the question around, you’ll see what I mean. Rather than “should I pay the minimum on this loan at 3% interest so I can invest and make 8-10%?” ask yourself “would I borrow money at 3% interest to invest and potentially make 8-10%?” Uhh…no. When you look at the question that way, the risk is more in-your-face. The thing is, though, borrowing at 3% interest to invest is really no different from holding onto a loan at 3% interest to invest. When you invest while you’re in debt, any losses in the market are magnified by the fact that you’re essentially buying on margin. Each dip in the market leads to a far greater effective loss to your portfolio. In his commentary on TPP’s post, PoF gave an example that clearly illustrates the risks of such investments:
“[L]et’s say he’s got $110,000 invested in stocks and $100,000 remaining on his student loans. Leaving out other assets for the sake of simplicity, he’s got a net worth of $10,000 and $100,000 is invested in stocks. That’s like a 1,000% stock allocation. A 10% drop in the value of the stock market (like we had last month) would wipe out his entire net worth!”
Moreover, every dollar you pay in interest is a dollar that can’t work for you to help you reach your goals. Wouldn’t you rather be on the other side of this equation earning interest, rather than paying it out? The sooner you pay off your debt, the sooner you can pour all of your extra income into your investments. To one of TPP’s points, your savings rate would be higher, as well, because you no longer have creditors claiming huge chunks of your money before it even hits your bank account.
I’ve got Warren Buffett and Mr. Money Mustache on my side
Warren Buffett, arguably the greatest investor of our time, strongly warns against using borrowed money to purchase investments in his latest letter to shareholders. Quoting Rudyard Kipling’s “If,” he sagely advises against investing while burdened by debt so that you’re more likely to “keep your head when all about you are losing theirs” in a market downturn. I don’t know about you, but I trust the Oracle’s judgment. Another wise money man, Mr. Money Mustache, yelled at me and put me to shame through the interwebs about my huge, flaming debt emergency. I’ll be the first to admit that “Mustachian” is not the first word anyone would use to describe me…and not just because people who know me don’t know what “Mustachian” means. 🙂 Nevertheless, I can’t disagree with wisdom:
“If you still have a car loan, credit card, department store or even a student loan debt, you should destroy that as a prerequisite to beginning the more relaxed stage of saving for financial independence. At the later stages, you can start to take it easy, but right now is the time for some hard work.” — MMM
Well-said, MMM. Well-said.
The difference for us
As I mentioned, up until last year, we were maxing our retirement accounts and investing heavily. A few months into our debt payoff journey, we decided to back down the investments to focus on paying off our debt as quickly as possible. Guys, backing down on investing has made a HUGE impact on our progress. Last year, we paid off a little under $50,000. In the first two months of this year, we’ve already paid off over $21,000! Our decision to decrease our investments is not the only factor in our increased payoff this year, but that decision jump-started our journey and has been a major factor in our progress. Once we pay off our debt, we’ll be able to invest to our heart’s content to reach our financial goals without worrying about debt dragging our income down. At the end of the day, personal finance is personal, so neither argument is truly wrong. But as I told TPP, one is definitely more right than the other. 🙂 Reprinted with the permission of TheirMoneyGoals.com.