The correct way to look at debt …

BradOK asks:

What’s a better use of my money – pay down debt or invest it in the market?

To which JillyBean responded:

At what rate of interest is your debt? How much debt do you have? Do you have an emergency fund? If you invest your money, what is the purpose for the money — short term or long term? The markets are on a downward spiral and very volatile — it might be more prudent to answer the above questions to determine the answer for the actual question.

You could always compromise and do both! It never is bad to pay down debt.

But, I am always working from the assumption that you want to get rich /stay rich …

… if that’s also your mindset, you might have more clarity if you rephrased the original question as “what’s better, to INVEST in debt or INVEST in the market?”

Once it’s clear that you are making an INVESTMENT every time you pay off debt – even personal debt – or, decide not to, then you will realize that you simply need to consider relative returns.

Then it will suddenly become clear that INVESTING in debt returns you a guaranteed rate equivalent to the interest rate (plus ongoing fees, if any) being charged. On the other hand, investing elsewhere MIGHT return more, over the long-term.

So, your real question that you need to answer is: “What investment will give me a greater AFTER TAX return than my highest interest rate currently outstanding debt?”

If you can find one (and, you have the required skills/interest/knowledge/stamina) then invest in that, otherwise pay down some debt.

Naturally, start with the highest interest rate debts first and work your way down (remember the ‘debt avalanch’?)

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10 thoughts on “The correct way to look at debt …

  1. ” What investment will give me a greater AFTER TAX return”

    The average person works 40 hours a week, and frankly they will not have the time to research this

    I think the short answer is pay off the debt since it requires no homework or additional skills.

    I did both: paid off debt and invested and saved, everyone personality towards money is different. There is no one size fits all in the world of personal finance

    It depends of his risk level and money style

    Some people are conservative and some are aggresive

  2. “The average person works 40 hours a week, and frankly they will not have the time to research this”

    Unfortunately for those who feel this way, they will probably have to continue to work 40 hours per week the rest of their lives.

    This post is just clearly demonstrating the fasted possible way toward building the largest investment portfolio you possibly can, in the shortest amount of given time, regardless of a persons risk aversion or comfort zones.

  3. @ MoneyMonk – I agree, personal finance is exactly that: personal.

    But, BradOK’s question was a simple one: what’s the BEST use of his money. From a financial perspective, that’s by putting it into the investment that provides the highest return.

    @ Scott – Working ONLY 40 hours a week; that’s a luxury that doctors and entrepreneurs can’t afford 😉

  4. For me, the interest rate would be a big factor in the decision making. Let’s take my home mortgage. I have a 30 year fixed loan at 5.375% which is pretty cheap money regardless of taxes. However it gets even cheaper when you consider the mortgage interest tax deduction and inflation (which means I’m paying the loan with future cheaper dollars.

    I’m not spring loaded to pay that debt down and would rather invest than pre-pay. Same argument would stand for a low interest student loan. I’m guessing, but I bet Scott has a couple of these that he factors into his decision making.

    Now on the other hand if interest rates on my debt were in the area of say 7-10% (which still isn’t as high as some folks have on their consumer credit cards), I’d be a bit more inclined to pay down the debt rather than invest.

    AJC hits this debt paydown point above and calls it an investment as well, however, I view it more as a cost avoidance vice investment. But that’s probably a small dogs vs. puppies point.

    [link removed]

  5. @ Jeff – provided that you are committed to using the mortgage (or other current debt payment) as investment money, then the semantic difference is critical to thinking about this correctly. Which is also why I say why would you pay down a deductible 7% – 10% loan IF a 12% – 15% (or better) investment is within your range (of interest/skill/etc.)?

    I say IF because if you are looking at only investing in CD’s to Mutual Funds, then your 10% range is probably spot on.

    BTW: the only links allowed in posts are relevant links to specific articles etc. … if relevant these CAN be on your own blog.

  6. AJC –

    Let’s change the discussion just a bit. Assuming debt other than a mortgage (so now there are no real tax implications, only inflation) where do you think the interest rate decision point is.

    My opinion is to still compare your debt interest to prevailing debt rates (is it cheap money compared to what else is available?), how does inflation affect the rate (cheaper future dollars point again) and can I out perform the debt rates with the investment opportunity that is competing for this money.

    Without the tax advantage, I’m more inclined to pay off the debt, i.e. lower tolerance for high debt interest.

    I haven’t done any math on it…yet, but my gut feel is that 6% or higher on the debt and I’d be giving serious thought to paying off the loans.


  7. @ Jeff – If I am serious about investing (i.e. as a Making Money 201 activity), I am struggling to find a scenario where putting my money into REDUCING leverage (by paying down existing loans) returns more that taking on new ‘good’ debt (e.g. to support a ‘good’ real-estate investment).

  8. Adrian, I like the idea of thinking of them (all of them, which are merely different choices) as investments. That’s definitely in an MBA toolbox!

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