For many investors, it’s difficult to decide whether to pay down low-interest debt or use available cash to invest. On one hand, people highly value being debt free. But on the other hand, people can do basic math. Borrowing money at 1.9% and expecting to receive an 8% return seems pretty attractive.
There really is no right answer to this question. One of the great things about personal finance is that it’s personal to you. I put together the following pro/con list because the question comes up so often. Let me know which camp you belong to in the comments below.
The case for paying off debt
- Flip the Question. Would you borrow cash at 1.9% to invest with the hope of earning more than what it costs to service your debt? When you’re examining the question, there’s no difference between these two scenarios. Many people will choose to invest when deciding between paying down low-interest debt or investing but would never borrow from a bank to invest on margin. If you’re not a fan of investing on margin, you should make sure you’re looking at this question through the right lens.
- Being Debt Free Feels Good. When I paid off my student loans, for the first time in decades I found myself completely 100% debt free. And you know what? It felt magical (and still does). I don’t owe anything to anybody. I’m sure that will change if I take on a mortgage in the future, but living debt free is addictive. I recognize that people have different feelings about this, but I encourage you to give yourself the feeling of being debt free and see if you like it. Once you’ve escaped the chains of your student loans and other consumer debt, I think you’ll be less likely to want to return to debt.
- Frees Up Cash Flow. If you have debt, you must make enough money to service it. This restricts your cash flow and keeps you from being able to do other stuff with your cash. If you’re investing the money, your investments could temporarily tank (i.e. 2008-2010). The auto loan doesn’t care that the money you invested is worth half as much as it was when you thought about paying cash for the car. You still need to make the monthly payment. If you want to change jobs, you’ll need to factor in the monthly payments on your debt as well. By signing up for the debt, you’ve committed to keeping your income at a certain level (base spending + debt servicing). If you change your mind, you’ll either have to sell your investment at a loss or incur capital gains. Neither option may be optimal.
- Where Do You Draw the Line? If you believe that investing is the way to go to take advantage of the spread, where do you draw the line? Should you finance your next iPhone purchase at 0% interest so you can invest the difference? How about a trip to Home Depot? A decade ago it was popular among personal finance bloggers to talk of a strategy borrowing from credit cards at 0% interest and parking the money in a high-yield savings account earning 5% interest. Since you could expect to get about 18 months interest-free, for every $10,000 you could arbitrage, you stood to make about $750, less taxes. This always struck me as a lot of work for a pretty small payday. If you’re using debt arbitrage to bulk up your investments, one should calculate your actual rate of return. Often the spread barely justifies the hassle of keeping up with the forms and accounts. It seems like a lot of mental energy for a small return. You’d probably be better served focusing on increasing your income.
- Complexity vs Simplicity. Warren Buffett said “There seems to be some perverse human characteristic that likes to make easy things difficult.” By getting caught up in the question, you’re undoubtedly making something simple more difficult. Most of our lives only get more complicated as time goes on (i.e. marriage, kids, health, mortgage) and there’s something to be said about simplifying your financial life. For one thing, I hope this blog is showing that your financial life doesn’t need to be complicated. If you’d rather focus your life energy on something else, paying off the debt is an easy choice. Once the debt is paid off, it disappears from your life completely.
The case for investing
- Math. It’s pretty obvious, but if you can borrow money at a lower rate than you receive on an investment, you will make money. If we assume a 1.9% loan and a 8% investment return, the difference is a mere $610 on a $10,000 loan. But if you run the scenario for 50 years, if you invest $10,000 at 8% per year you’ll have $469,016 in 50 years. Meanwhile, your measly auto loan will only be $25,627, this letting you pocket the difference of $443,389. That’s not exactly chump change (of course, don’t forget that in 50 years $400K won’t be worth nearly what it’s worth today thanks to the ravages of inflation).
- Limited Access to Retirement Accounts. The most compelling reason to invest rather than pay down the debt is if you otherwise wouldn’t be able to max out your retirement accounts. Annual retirement space is “use or it lose it”, so if you neglect to contribute to your 401(k) this year while you’re busy paying down a 1.9% loan, there’s no opportunity to catch up next year. If I was in this situation, I’d almost certainly do whatever it takes to max out retirement savings before I paid down a low interest debt (including student loans). The benefits of retirement accounts and the tax arbitrage are just too great.
- Set Up Autopay. Carrying the debt isn’t that complicated. Sure, it’s one more account to keep track of and of course you need to be careful that you don’t make a mistake that causes the interest rate to jump up. But that’s easily handled by setting up automatic payments. Set it once and then forget it.
- Forced Savings. By keeping the loan and requiring yourself to make monthly payments to service it, you’ve effectively forced yourself to save. For example, if you have $10,000 set aside for a car but decide to take out a loan instead and to throw your $10,000 into Vanguard, you’ve basically committed yourself to saving $10,000 by making the loans payments. There’s something to be said for putting your back up against a wall and requiring your future self to save. If you pay for the car in cash, there’s no certainty that you’ll spend the next few years saving the equivalent of a car payment each month. By opening yourself to the opportunity of reallocating the money to something else, you’re setting up the possibility of failure.
- How About a 0% Loan? Sure, you might not go to a bank to borrow 1.9% with the hope of making a great return in the stock market. But would you do it if they offered a 0% loan? What if someone said they’d give you a $1 million loan at 0% interest for 5 years. Would you take it? I would. $1 million in a 5-year CD earns 2.0%, so that’d be a cool $20,000 a year for almost no risk. If you’re reluctant to borrow at 0%, what about -1%? If this is convincing to you, we’re no longer talking about whether you’d invest on margin, we’re negotiating on the price. So while 3-4% might seem unattractive, when rates start to get closer to 0% it might feel like a better deal.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.