Paying Off Your Debt Or Investing: The Next Move

It’s really important to know where your advice is coming from and how the person giving you that advice gets paid.  Conflicts of interest are given at the beginning of every talk for a reason.  They can be powerful.  For example, how someone answers the question of whether you should be investing your money or paying off your debt will differ depending on who is answering your question.

This exact conversation came up the other day with a good friend of mine.  My friend wanted to know if his family’s income would be better used in a taxable account or paying off his student loan debt?

Importantly, it was a good talk that I feel will benefit a lot of readers.

Let’s dig in.

The Scenario

Here are the circumstances of the discussion (changed to protect the innocent):

  • Both spouses are high-income earners.
  • They have a substantial amount of debt (lets just say > $400,000) at 3% interest.
  • They are currently making minimum payments on their loans. The loans should be paid off in ~15 years.
  • A financial advisor is involved who earns 1% AUM (Assets under management) fees.
  • Their advisor places them in actively managed funds with an average expense ratio around 0.8%-1%.
  • They are already maxing out their 403B/401K and doing a Backdoor Roth for each of them

Given the above assumptions, which again have been slightly changed to keep the innocent blameless, the question was this:

Should my friend put the family income into a taxable account
or use it to pay off the high student loan debt burden?

Conflicts of Interest and added costs

It bears repeating, who answers this question will vary widely dependent on how conflicted the person is giving the advice.

For example, a financial advisor who earns 1% on all the money he helps manage will be immediately decreasing any income he earns by telling this couple to put their money towards the debt instead of into the taxable account he manages. That’s a conflict of interest.

That’s not to say that a good financial advisor wouldn’t do this.  There are good ones out there, for sure who would advise you to do what’s best regardless of how it impacts their bottom line.

By asking me, my friend realized I am not earning a penny from this advice.  My only conflict of interest is making sure my friend and his spouse made an intentional decision that was right for them.

A conflict of caring too much is probably not a conflict of interest at all.

Two sides: Paying Off Your Debt versus Investing Your Money

There are reasonable people on both sides of this argument. We will call the first group the “Debt Destroyer” Group.  We will call the second the “Market Math” group.

Argument from the Debt Destroyer Group

Paying off the debt provides such an emotional release from being out from under debt.  Also, when you are debt free, you can take whatever money you were putting into your loans and then put that into investment vehicles.

Plus, you’ll save the interest you would have paid and invest that, too!

Argument from the Market Math Group

The other group thinks: As long as we earn more interest in the market than those pesky 3% loans are costing us, then we will make out ahead. So, let’s just put the money into the market.

This is for the cold-hearted logician!

Or is it…

A Helpful Thought Experiment 

How would you advise this couple?

Speaking of math and numbers, let’s look at some of them from my friend’s situation above.

  • The cost of the financial advisor is 1%
  • The cost of the actively managed funds above is about 1%
  • Inflation rises on average 2-3% per year
  • The student loan payment provides a guaranteed 3% interest versus the gamble in the market

Even if you are being conservative when combining these numbers, you should add my friend’s 3% guarantee when paying down his loans + 1% advisor fee + ~1% expense ratios.

That is a 5% guarantee towards building wealth by paying down his debt instead of putting money into a taxable account.  That doesn’t even count the inflation he is trying to beat in the market.

So, the crux of this decision is really the following.  How big of a gambler are you?

Do you think your market investments will easily beat 5% gains?

Which team would you be on?  The Debt Destroyer Team or the Market Math Team?

This is where personal finance gets personal.  Everyone might give a different answer.
I personally sided with paying off your debt.

We’re still not done…

But the thought experiment still isn’t done.  What about all that interest my friend didn’t pay that he could then put into investment vehicles after the loans are gone?

Well, on $400,000 at 3% interest with minimum payments for 15 years he can anticipate accumulating about $100,000 in interest.

Instead, he could pay it off in two years, and save himself $90,000 in interest in addition to not having to beat 5% in the market.

Then he could take the monthly payment he was putting towards his debt + the interest he saved himself and plug away at his taxable account.

Now that sounds like a winning recipe.

Not just an emotional argument

Being debt free is a huge mile stone.  So is being student loan debt free.  I encourage you to celebrate both!

Whether being debt free is a big goal for someone is going to be highly personal and individualized.

Many people make the behavioral finance argument that getting rid of debt is the winning method because it teaches you better financial habits (not normalizing debt).  When you feel like debt is filthy, it makes it a little easier to want to be cleansed of it.

That said, the above numbers show that it isn’t simply an emotional or behavioral finance argument.  The Debt Destroyer team can win their fight with math and logic, too.

Dr. Cory S. Fawcett wrote a great book on Eliminating Debt for Doctors (I write a review here).  If you don’t hate your debt, go read that book.

Take Home and some guidelines

I am all about intentional decisions.

As long as people have the information they need and it is the right information, I think most people will make a good decision.

Your investment philosophy can certainly impact how quickly you get rid of your debt.  So, what do I recommend?

Here’s the outline to follow for pretty much everyone.  Then, I’ll show you where the real fork in the road is:

Room to Invest Your Money While you Pay Off Debt
Debt to income ratio is <1 OR you are in PSLF
(i.e. $250,000 in debt with $300,000 in annual income)

  1. Max out your 401K/403B for both you and your spouse (if married) to at least receive all matches and contributions from your employer.
    1. Make the above in a pre-tax fashion so you can put extra post-tax money towards your debt.
  2. Max out any governmental 457 for you and your spouse, if you have one.
  3. Max out your backdoor Roth space for both you and your spouse (if married).
  4. If in PSLF, make minimum payments and max out other investment vehicles (taxable account, etc).
  5. If not in PSLF, privately refinance and use any extra money after Step 3 towards destroying your debt.

Paying Off Your Debt at All Costs
Debt to income ratio is >1.5-2
(i.e. $450,000-$600,000 in debt; $300,000 in annual income)

  1. Make sure you take advantage of PSLF, if you can!  In this situation, starting PSLF now (if you’ve missed out on previous payments) may still be the best choice.
  2. Max our your 401K/403B for both you and your spouse (if married) to at least receive all matches and contributions from your employer.
    1. Make the above in a pre-tax fashion so you can put extra post-tax money towards your debt.
  3. Every extra dollar should go towards debt in this situation if you are not doing PSLF.
  4. See the step above this… every extra dollar towards debt.

If you want to learn more about my thoughts on Destroying Debt, sign up for my weekly newsletter (to the right in web browser or below this if reading on a phone) and you’ll get access to my Student Loan Debt Destroyer Email Course.

You can obviously tell, I am on the Debt Destroyer Team.  Which team would you be on if you were my friend?  What would you advise that family to do?  Leave a comment below.

TPP

8 thoughts on “Paying Off Your Debt Or Investing: The Next Move

  1. Another takeaway: If you choose to use a financial advisor, use a fee-based advisor instead of one who is paid on AUM. It’s a quick and easy way to get rid of the conflict of interest, and for high income earners like those discussed in this post a fee based solution will probably save them a lot of money in the long run.

    P.S. I’m Team Debt Destroyer. You should make t-shirts.

  2. I think this question could be viewed as what should one do with the extra ~$14.4k per month that this couple has after making their minimum payment on their debt. This is assuming a monthly payment of ~$2760 (to pay down $400k in 15 years at 3%) with $17.2k in available monthly cashflow (to pay down $400k in 2 years at 3% as you suggested they could).

    Your argue to destroy debt because (a) debt free = goodness (a fine reason) and (b) avoid paying interest for ~13 years. No arguments here from point a – as we’re approaching things much in the way a ‘Debt Destroyer’ would – but I do want to play devil’s advocate as it relates to point b:

    While yes, it’s true that much in the way of interest will be avoided if loan payment is expedited, I would consider the opportunity cost of that decision. If the persons in question plan to work for at least 15 years – perhaps a big assumption – the loans will be gone using either repayment strategy. So to me, the true question is whether you’d rather invest $14,400 each month for 15 years or invest nothing for two years and $17,200 to invest for 13 years.

    What it boils down to for me is the investors will have a contributed ~$345k more than the debt destroyers and for the next 13 years, the debt destroyers will have an extra $2700 monthly contribution to try and catch up.

    And I’d also argue that inflation works both ways. While the investor’s gains have to be considered relative to inflation, so do the loan payments. A $2700 monthly payment in year 15 is not the same as it is in year 1. Citing your 2-3% inflation rate, you could make the argument that the inflation-adjusted rates on the student loans are 0-1%.

    In our case, we’ve chosen to focus on debt reduction (loans sub-3%) before contributing to taxable investment, but we do max tax-deferred contributions before extra principle payments on our student loan debt.

    • I definitely have found reasonable people on both sides of this argument.

      The hard part is that this isn’t a decision about paying off debt versus investing in tax-advantaged space, which is an easy decision as long as your debt is not insurmountable.

      This couple maxes tax-deferred contributions before extra student loan payments as well. Maxed out 403B and 401K + backdoor Roth for each.

      The additional money would go into a taxable account (where gains are taxed at LTCG tax) or into paying off debt. Also, the long-term payment timeline limits any options of FIRE for this couple, should they choose to go that route. It doesn’t eliminate the option, but being “Financially Independent” does imply that you are debt free.

      I do agree that inflation needs to be considered either way, for sure.

  3. To put a slightly different light on it…which is the “least risky”?

    Recently I faced a choice…keep money in the market, or pay off a 3.5% mortgage….

    The calculus that made the most sense to me was ….if the market fell, the debt is still owed. The least risk was to pay off the mortgage. So I did.

    No doubt the math favors investing over paying off the mortgage…as long as the stock market continues upward. As William Bernstein said when asked where the market was heading…”how the h#ll do I know?”

    If you are debt-free, the vagaries of market movement, the Brownian movement of hospital administrators and other random financial factors are much less worrisome.

    I’m firmly in the “pay off debt” camp (after maxing out tax advantaged accounts).

    • I like looking at it that way, too. It is a more guaranteed “return on investment” if you want to think of it that way.

      Once my loans are gone, I’ll likely take a mixed approach. Early payments to mortgage while I put money into our taxable account.

      But I am definitely a fan of filling up tax advantaged space first, then student loan debt, then taxable account.

      Mortgages are a hot button topic with lots of different opinions. I’ll cross that bridge when I get there and may come over to your side. I certainly know Cory Fawcett would agree with you, too!

  4. Another consideration is that it doesn’t have to be a binary decision. You could hedge by splitting between the two in some way. I think it would be totally reasonable to pay down debt aggressively while still making meaningful contributions to investments (beyond the tax-sheltered accounts). Also, there’s no reason the couple couldn’t make a lump sum payment and some point prior to or at the point of reaching financial independence.

    With student loans at this level (on the order of 3%), the arguments are very similar to those made for/against paying down a low interest mortgage.

    • I agree to some extent. I am a hater of debt. So it’s not binary for me if the decision is close. Just get rid of it.

      If the decision heavily favors investing, I get that.

      They could make a lump sum using money that cost them 3% interest in addition to the long term capital gains taxes they would have to pay to do that.

      I like simple, personally.

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