Is it Better to Invest or Pay Off Debt?

Is it better to invest or pay off debt?” Given all the news these days about the crushing amounts of debt American households are facing, it may seem like a far fetched question. However, it’s one that people ask us on a fairly regular basis. And the answer is, “it’s complicated.” Most of the time it is better to pay off your debt rather than invest, because your debt usually has higher interest rates. But there are lots of factors that can change this calculation. So we thought we’d take a look at a couple of scenarios to give you a better understanding of how your investments (or savings) relate to your credit card debt. Hopefully in the end you will be able to make a more informed decision about whether or not it is a good idea for you to consider paying off your debt with your investments.

How Investments Compare to Debt

First we should start with a concept that is used by anyone who uses money, but may be completely unknown to many of us: fungibility. Put simply, fungibility is the idea that money is entirely interchangeable. Lets say for instance that I have $10 in my wallet and $10 dollars in my banking account accessible by my Debit card. I find myself at the local grocery store with a bottle of wine totaling $9.75.

Does it matter if I use the $10 in cash I have in my pocket, or if I use the $10 I have in my debit account to pay?

Putting aside practical concerns about having cash in case a store doesn’t accept debit, from a purely financial perspective, does it matter which $10 I use? No, it shouldn’t, and this is because the $10 in my pocket is worth, financially, the same as the $10 in my debit account. This is the concept of fungibility: the property of a good or a commodity whose individual units are capable of mutual substitution. In this case, the value of a dollar is the same, no matter which dollar I choose to use.

Any dollar is going to represent the same amount of value as any other dollar, and while what that value actually is may change over time, all dollars I come across will represent the same value. So while $1 in 1980 may have bought you more chewing gum than $1 in 2011, any $1 bill we came across in 1980 would buy the same amount of gum as any other 1980 dollar, just as any $1 in 2011 will buy the same amount of gum as any other. A dollar is a dollar, no matter where it comes from.

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Interestingly, this has some ramifications for your personal finance. Thanks to fungibility anything you do within your financial picture with money adds up to the same financial bottom line, since all of your dollars are interchangeable. So for instance, if your grandparents give you a nice big check for your birthday, but make you promise that it won’t be used for anything other than groceries. You can’t wiggle around that promise by going out and buying a big screen TV on credit, then use your income to pay the credit down, and use the birthday money to replace the income you would have used for groceries to buy groceries.

Its all the same money thanks to fungibility! It all adds up to the same financial big picture, just like $10 in your wallet and $10 in your debit account add up to mean you can afford $20 worth of wine.

So let’s apply this thinking to debt and investments. Both have dollar value, so both of them factor into the same interchangeable financial picture. $20,000 in a savings account and $20,000 in credit card debt add up to a $0 net worth, if the actual dollar amount is all we consider (for the sake of simplicity we will only evaluate debts in terms of their absolute value). Thanks to fungibility, having $20K while owing $20K is no different than having $0 because all those dollars are the same, and the negative dollars owed cancel out the positive wealth.

The one small detail that makes this picture significantly more complicated is: growth. Both investments and debts grow at a particular rate. Credit cards have their ‘APR’, bonds have yields, stocks have equity, and savings accounts have interest. So while all things being equal $20K in debt and $20K in savings means $0 net worth, those amounts may be significantly different given a bit of time and growth. In one year a $20,000 savings account earning 1% interest will be worth $20,200, whereas $20,000 in credit card debt with a 15% APR will have a value of $23,000.

So our debts may be worth significantly different amounts than our savings or investments over time, but thanks to fungibility they end up contributing to the same bottom line. This is where the picture becomes complicated. Actually comparing a particular investment to a particular debt over time and how they each contribute to our bottom line involves a lot of variables and a lot of moving parts.

This is exactly why it’s so difficult for people to do, and exactly why we decided to try and help.  Unfortunately it is hard to give absolute “cover all” advice and say that in all cases for all people you are better off paying your debts off with your investments. All cases should be evaluated on an individual basis with all factors carefully weighed and evaluated. There are, however, still valuable lessons and conclusions to be learned by looking at a few scenarios. So let’s run a few controlled experiments and see what we find out!

Debt: Is it More Powerful than an Investment?

First we should start by defining a few of the variables in this picture as constants. Let’s imagine a man named Tom. Tom is an average guy who has been working a steady job for the last 10 years after graduating college. He has managed to put away and save $20,000, but he has also amassed some credit card debt totalling $20,000. Lets say that Tom has his savings invested in a mutual fund that is growing at an average annualised rate of 6% per year. Unfortunately, Toms’ $20,000 in credit card debt has an APR of 15% per year.

Also we should assume that Tom is a very well behaved man and in a strangely stable part of his life, such that he will not make a single charge on his card until it is completely paid off. We should pretend for the sake of simplicity that his mutual fund investment will grow at 6% every year no matter what the stock market or economy does. Tom is also able to afford to pay around $500 a month on his credit card debt.

What should Tom do? In the long term, would it be better for Tom to keep the investment, and pay down his debt? Or would it better for Tom to use his investment to pay off his debt, and start over with his savings for the future by investing the money he would be paying towards the credit card back into that same mutual fund? Lets call the first course of action the “Let it Ride” option, and lets call the second the “Re-Investing” option.

Lets start with the first comparison:

 

So here we see that the “Re-Invest” option beat the “Let it Ride” option, in terms of financial gain, over the course of 57 month by about $8,000. In other words If Tom were to use his investments to pay off his credit card debt, and invest $500 for 57 months into the same mutual fund earning 6%, then he would be $8,000 richer than if he had held on to his investments and paid down his debts $500 each month. You may be asking yourself why the time horizon for this chart is 57 months – this is because a debt of $20,000 with a 15% APR would take 57 months to pay off if you were making $500 payments each month. $8,000 after nearly 5 years is not a bad proposition, especially considering that Tom would be completely debt free at the end of it, with a positive net worth of $31,000.

To be fair, not everyone can afford to pay $500 a month towards their credit card, even if they have $20k lying around in investments! So perhaps our last scenario was a bit unrealistic.

Second comparison:

So this scenario is a lot like the previous one. However, in this instance rather than assuming the monthly payment Tom makes is $500, Tom will make the minimum payments required by the credit card company. We will calculate it with a formula widely used by card companies. Let’s assume that the minimum payment required is: that months accrued interest (assuming 15% APR) plus 1% of the remaining balance. In addition to this it should be assumed that rather than paying his debt off when it reached $1,000, Tom instead sets a minimum he was willing to pay each month at $100. So that once the minimum payments he was required to pay dropped below $100, he continues to pay $100 for each month remaining until his debt is paid off.

Here again we see that the “Let it Ride” option is beaten out by the “Re-Invest” option. Only in this case, when we used the minimum payment formula, the time it took to pay off the card ballooned to 211 months. This was also in-spite of the fact that Tom set his own minimum payment threshold at $100, and as a consequence paid over the minimum required payment for 62 months. This time, thanks to the large time horizon, the “Re-Invest” option beat the “Let it Ride” option by a whopping $26,000.

So, Should I Invest or Pay Off Debt?

Lets wrap up with a few conclusions and some remarks about what was learned by crunching these numbers. From the scenarios we have seen, we can conclude that the best option (financially) for someone in Tom’s situation is to cash out their investments, pay off their debt with the proceeds, and re-invest the money that they would have been paying each month against their debt. The amount by which they will be better off in the future will depend upon the rate at which they would pay down their debt.

This is a two way street though, as part of the reason the gap between the strategies of “Let it Ride” and “Re-Invest” is so large (in the case of making minimum payments) is because the time horizon is so long. In the case of larger payments, you give the options less time to mature and for the gap to grow because you pay off the debt that much faster. If you were to compare the performance of the “Let it Ride” strategy from scenarios one and two, and you were to allow the same time horizon for both you would find that they are roughly equivalent.

If we were to play with some of the variables in these scenarios we can learn some interesting facts. If the APR of the credit card were to increase, the gap between our two strategies would widen, meaning in the long term you would be even better off following the “Re-Invest” option. This is the case for several reasons: first, it increases the time it would take you to pay off your debt; second, it would increase the the rate at which your investment in the “Let it Ride” option would be beaten by the growth of your debt; and third; it would increase the rate at which you would pay into your investments in the “Re-Invest” strategy allowing them to grow faster in comparison.

Conversely if we were to reduce the APR it would have an effect in the opposite direction for the same reasons, meaning the gap between the “Let it Ride” and “Re-Invest” would narrow. It should be noted that our assumed APR of 15% is on the lower end of the spectrum. This means that in the real world APRs are likely to be higher, and the gap between our strategies therefore larger, again indicating that the “Re-Investment” strategy is the better of the two.

Changing the rate at which Tom’s investment grows would have a different effect than a change in the APR. A change in the investment yield would not only widen the gap between the two strategies so much as it would shift the chart up or down. An increase would raise the ultimate net wealth produced by following either strategy, while a decrease would lower it. This is because the return on investment is factored into both strategies as a positive force on one’s net wealth. It should also noted that assuming a 6% return on investment may not be the best assumption. Real investments involve risk, and while a 6% return isn’t unheard of it may not be a sure bet.

Historically financial markets (Stocks) have been able to return 5-8%. However this is over their entire history, and it is a bad idea to assume that for any given time window the markets will perform to that standard. A look at the last few years of market turmoil can attest to that. So while we have made the assumption that Tom’s investment of choice returns a steady 6% for the sake of simplicity, the reality of what you can expect is far less certain. With this in mind, it should be noted that while investments can fluctuate, the rate at which your credit card debt grows doesn’t.

This means that since both of our discussed strategies involve an investment, that they are both at least in part a gamble. The difference is that in the “Let it ride” strategy you are relying more on your investment and its growth to offset the value and growth of your debt as you pay it down. In the “Re-Invest” case, you are merely relying on the investment for growth. Consider this, if in the middle of our first scenario the stock market crashed and you were to lose all of your investment, you would still be in considerable debt if you had been following the “Let it Ride” strategy. Whereas if you had been following the “Re-Invest” strategy you would have only lost what ever it was you had paid in, and returned to a level of $0 of net wealth.

It is also important to understand that to be able to accurately compare the two options, it must be assumed that when Tom follows the “Re-Invest” strategy he is vigilant to invest the money he would have been paying towards his credit card if he were to follow the “Let it Ride” strategy. This is necessary because it is the only way that we can measure accurately the long term financial advantage that one has by paying off their debts with their investments. Essentially there would be nothing to compare long term, other than giving a monetary value to the amount of interest he would have paid in the process of paying his card off, if Tom was to merely pocket the money he would be paying.

While there may be a lot of value to Tom, and quite an advantage gained, in having extra money in his pocket each month, it is hard to compare the value it brings him to the financial value between our two strategies in the long run. It’s akin to comparing apples to oranges, it’s not that one is better than the other, but rather that each has their own positives. For the sake of our experiments the long term financial advantage was chosen as the deciding factor for which strategy was better, because it was the easiest to quantify and compare to the burden of debt.

Lastly, it is important to note that our scenarios were performed in a vacuum, where only the factors we have assumed are involved. In reality cashing in one’s investments to pay off your debt may involve several more financial externalities to be considered. Fees, capital gains tax, shifts in income tax, penalties and fines should all be considered and factored into the equation if Tom was to accurately weigh his options. Odds are that if you have a significant investment, that you also have access to a financial planner whom you should consult if you are considering your options.

To summarize, it would appear that in almost all cases, barring some externalities to cashing in investments, Tom would be financially better off in the long term following our strategy of “Re-investing.” In other words it is better to use one’s investments to pay off their debt and invest what they would have made in monthly payments, than to hold onto both their investments and their debts while paying that debt down. While we haven’t proven it in this post, we can theorize that this would hold true in all cases where the rate of growth on the debt (the APR) exceeds the rate of growth on the investment (the yield). Given two investments that grow at different rates, the one that grows faster will be larger given the same amount of time. It is true that in the vast majority of cases credit card debt grows faster than investments.

This article is part of our Credit Card Debt Resource Center.  If you’re looking for additional information about credit card debt, be sure to pay a visit!

Image 1 credit: kenteegardin; Image 2 credit: Refracted Moments™; Image 3 credit: Paul Robertson; Image 4 credit: herval

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  • Zack Jones

    Very interesting post! I did see one thing that looks wrong to me in paragraph just above “So, Should I Invest or Pay Off Debt?” – First sentence reads “Here again we see that the “Let it Ride” option is beaten out by the “Re-Invest” option.” The chart above that shows it differently. In the chart Re-Invest has a higher net worth.

    I’d like to hear your thoughts on the following scenario. Mortgage of $225,000 at 4.5%, monthly payments of $1300. After paying off debt and fully funding emergency fund I’ll have $1500 per month extra to either invest or pay towards mortgage. Currently putting in 5% into company 401(k) to get company match. (Maxed out in previous years current balance $350K). Plan to work until 65 (2027).

    Plan A – Apply $1500 on top of $1300 and pay off house very quickly. (2020 VS 2042) Then have $2800 per month to invest.
    Plan B – Invest $1500 in combination of Roth IRA (6000 x 2 wife and I are over 50) and remainder into company Roth 401(k)
    Plan C – Invest $100  per month into Roth IRAs and $500 extra towards mortgage (2028 vs 2042 for mortgage)
    Plan D – Invest $750 per month inro Roth IRAs and $750 extra towards mortgage (2025 vs 2042 for mortgage)

    Plan ? – What would you do?

  • http://www.readyforzero.com ReadyForZero

    Hi Zack.

    Great question! I wish there was a “right” answer I could give you, but there really isn’t one. What clouds the situation you are in is: what can you safely assume the yield on your investment (401k or Roth) to be? Furthermore, since we are not bound by any fiduciary relationship, I cant really give you much direct advice.

    But that really is the trillion dollar question. What can I safely assume my return on investment is? If you have an answer to it, you should work in High Finance!

    Are you willing to assume that your rate of return is higher than 4.5%? If so then you may be better off long term, investing your extra income now. If not, paying off that mortgage could be your best bet.

    It is hard to predict how fast your investments will grow, but you can be 100% certain that your Mortgage debt will be growing at 4.5%. Based on this fact, and some of the lessons learned in my study, paying down your debt is never a ‘Bad” idea. (see the 5th to last paragraph) Or at the very least it can be the most pragmatic and conservative choice of the options available.

    Ask yourself would you rather:

    Have $0 in debt AND $0 in investment with no risk?
    Or
    Have $X amount of debt AND $X amount of investment with some risk?

    If you are serious about exploring your options I suggest you contact a Certified Financial Planner for a consultation (http://www.cfp.net/). They could give you a more concrete answer for a nominal fee.

    ~Bobby

    • Zack Jones

      Thanks for the reply, Bobby and I realize you can’t make specific recommendations. I suppose I should have worded it more as a what-if scenario. I hadn’t really considered rates of return and along with that we have to consider inflation. You’ve given me more things to think about. It’s going to be a while before I’m ready to put a ton of money into either investing or the mortgage. I have some consumer debt to knock out which will be done this year and then the emergency fund to fully fund so I have a while to ponder my options. 

      Thanks again for the great post and all of the things you guys do at ReadyForZero!

  • http://www.smartwealth.org/ Evan @Smartwealth

    I have always thought of it the same way you mentioned, what has a higher rate, if your investment has the higher rate than the debt you carry it would only make sense to invest now and payoff debt when if the situation changes.  Great post, I loved the detailed analysis

    • http://www.readyforzero.com ReadyForZero

       Thanks Evan!

      I do really think that at the core of it, its all about the growth rates. What makes it ugly and complicated are the hidden fees, the penalties, the taxes, the fines….. ect ect ect.

      Guess we need to keep Financial Planners employed though :)

      ~Bobby

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  • David

    You forgot capital gains taxes and dividend taxes which lowers your 6% return to 4%. You get a guaranteed return of 5% by paying off your mortgage but with stocks there are no guarantees and a tons of risk involved.

    In 2008 the stock market or S&P 500 went down -37.22% which may take 5 years just to break even or to get a 0% return on your money. Bottom line is that a guaranteed 5% return is better than a risky 5% stock return after taxes.

    • http://www.readyforzero.com ReadyForZero

      You are absolutely right David!

      There a lot of little details that effect this calculation and have negative or positive effects on the long term results. Capital gains taxes, Inflation, brokerage fees, just to name a few. The calculations above where more or less done simply, if only to prove the concept.

      Your point about the current state of the S&P is spot on as well. With equities its all about your entry and exit point (barring dividends of course). The scary thing is that you can be invested for 10 years, and see 8% gains year after year, only to have the market crash in the 11th year and wipe all of your gains. That of course is IF you are lucky and the market doesn’t dip so far as to harm your original capital investment.

      -Bobby