After the “Interest Earned” (IE) series, you may have wondered, “Should I invest or pay off my debt?”
It’s a good question. If you are familiar with or follow Dave Ramsey, you know he takes a pretty hard line on this with his Baby Steps: His answer is, “Pay off your debt before you start long-term investing.” And if you understand his reasoning, it makes sense: you want to pay as little interest as possible and put all your focus on retiring your debts as quickly as possible before you start saving in a big way.
His strategy focuses on leveraging the psychological, emotional, and spiritual benefits of debt freedom to gain momentum. I completely understand and am supportive of it, especially if your debt burden is huge and your interest payments are high.
But if we take a step back and look at the question from a purely mathematical standpoint, the answer isn’t as obvious. We need to consider factors such as interest rates, age, life stage, debt type, risk appetite, and liquidity.
If you were to opt for a math-based approach, a very simplistic one would be to compare the interest rate on your debt with the investment returns you think you can get and allocate the money toward the option with the highest percentage. This makes some sense in theory, but only in the most obvious cases (and even then, it may not be the wisest choice, if for no other reason than we may have no idea what our annual return will be). Let’s look at an example,
Case #1: a somewhat “clear-cut” case. Jason is 28 years old and earns $60,000 per year. He has a dollar-for-dollar employer match in a 401(k) up to 3% of his salary, but he isn’t taking advantage of it. He has credit card debt of $10,000 at 20% APR (yours could be higher!). Jason has saved an emergency fund of three months’ salary ($15,000)—good for him! He has some margin in his expenses, so he has $500 extra per month to either invest or pay down his credit card debt. What should he do?
Dave would say, “Don’t be stup__, pay down the credit card debt!” With a $10k balance and 20% interest, that would be my initial response as well. That interest rate is REDICULOUS (but not abnormal)! However, Jason might also reasonably consider a more nuanced approach that gets him in—but not ‘all in’ with his $500—his employer's 401(k):
Invest 3% in a 401(k) to receive the 3% match. This will be ~$150/month invested.
Put the rest ($350) toward paying off his credit cards faster.
But does the math work? If Jason puts the whole $500 per month toward his $10,000 credit card debt at 20% interest, he’ll pay it off in about two years and spend around $2,200 in interest. Then he’s free to start investing the entire $500 in his 401(k) if he wants to, but he missed out on two years of his employer's match.
But if he instead contributes $150 per month to his 401(k) to get the full employer match (another $150 per month) and uses the remaining $350 (=$500 – $150) to pay down the debt, he’ll pay it off in about three years and spend roughly $3,200 in interest, about $1,000 more. However, the free employer match adds up to $5,400 over three years, and if left invested, Jason's contributions plus the employer match could grow to ~$80,000 based on a 7% annual return over 30 years. So, for a small increase in interest costs in the short term, Jason could have tens of thousands in extra savings later in life.
That said, I’m a big fan of getting out of debt, so I believe that paying off credit card debt as quickly as possible and then allocating $500 per month for investing is a reasonable choice. However, investing up to the match while also paying off credit cards quickly is also a sensible approach. From a purely mathematical perspective, the ‘nuanced’ approach could be the big winner.
Here’s what a generic ‘nuanced’ strategy in cases like this might look like: Aggressively pay down unsecured debt, especially credit card debt, while starting to build long-term savings by taking advantage of the employer’s match and no more (until debt is paid). Approximately 80% of any surplus would be allocated towards debt reduction, and 20% towards savings.
This ‘hybrid’ approach doesn’t work if you don’t have the surplus funds to do both. In that case, paying off debt as quickly as possible to free up a surplus for saving and investing is the better choice. You can play ‘catch up’ with your saving if you need to, but the sooner you pay off the debt, the less 'catching up’ you’ll have to do.
Next, let’s look at a trickier (i.e., not ‘clear cut’) situation. Assume that Jason has the same salary and employer 401(k) plan, and he contributes 3% to receive the 100% match. He also has a basic emergency fund (equivalent to three months’ salary). However, he has outstanding student loan debt of $10,000 at an interest rate of 5%. Fortunately, he still has $500 to invest or put toward his student loan. What should he do?
We all know that (most) debt is bad—or at best, not so bad—and most of us don’t like being in debt. I know people who have paid off a 3 or 4 percent house mortgage even though they could probably “invest” and earn more, simply for the peace of mind it gave them.
Dave Ramsey has built his whole philosophy and approach around the fact that the psychological, emotional, and spiritual impacts of being debt-free are profound, not to mention the practical benefits of having more money to spend, save, and give. This is precisely why this situation is especially tricky. However, I might suggest that Jason consider a more nuanced approach with this one as well.
Jason is young, his risk tolerance is high, and he’s investing for the long term, so his risk capacity is also high. He can weather market downturns and is likely to earn returns of 6% to 8% over time. From the simple math viewpoint, it wouldn’t seem to make sense to pay off his 5% loan early (especially if it’s a “simple interest” loan, which means it’s not accruing interest on interest); 5% interest is less than 6% to 8% compound interest.
Of course, future investment returns aren’t guaranteed, especially in the short term. In contrast, the ‘return’ you get by paying off your loan early is guaranteed (unless you refinance to a lower rate, which can complicate the calculation).
With a ‘hybrid’ approach, Jason would allocate 20% of the $500 to additional investing (perhaps in an IRA, since he is already receiving his employer match in his 401(k)). He would use 40% to increase his emergency fund from 3 months to 6 months, and the remaining 40% could go to paying down his student loan. Once his emergency fund reaches six months of salary, he could increase his investing to 40% of the $500 and increase his loan payoff to 60%. Once the loan is paid off, he’s free to use that 60% for additional saving or giving.
Mathematically, the ‘nuanced’ approach also works in this scenario. If Jason earns an average annual return of 7%, his investments could grow to $80,000 or more over a decade, while the loan’s additional interest cost would be approximately $885.
However, while the math favors investing up to a certain percentage, the emotional and spiritual freedom of being debt-free can’t be overlooked, which is why a blended approach may make sense for some people but not others. If becoming debt-free is your highest priority, delaying investing makes sense to achieve that goal as soon as possible. Or, if Jason’s student loan rate were 7% or 10% or more, it would make a lot more sense for him to pay off the loan and forego any of the other options until he does.
Taking all this into account, a more nuanced approach in a situation like this might look like this:
These percentages are not precise; they are intended to be illustrative of a more nuanced approach that you might take and adjust them accordingly based on the specifics of your situation, taking into account the size (and cost) of your debt.
Let’s consider a final case where someone has no emergency fund and is burdened with both short-term credit card debt and long-term student loan debt. This is a common scenario for someone who has recently finished college and is starting their first job. In this case, it may be best to go ‘all-in’ to eliminate the debt, but if they are disciplined enough, there is a more nuanced approach that might also work for them. It’s a 3-phase approach:
Phase 1–Pay down unsecured debt (includes Student Loan debt) while building your emergency fund. During this time, approximately 80% of your surplus can be allocated towards debt reduction, and 20% towards savings.
Phase 2–Fill your emergency fund to reach 3-6 months of Living Expenses. During this time, 80%-100% of your surplus should go towards savings and 0 - 20% towards investments. This phase should also include paying off any car loans first before investing (shown as 20%).
Phase 3–Invest for the future and replace any savings that you spend as you incur unexpected expenses. This phase could also include paying off low-interest school loans and home equity loans. Once that’s done, you could turn your attention to paying off your mortgage early by paying down the principal.
If you decide to use one of the ‘nuanced’ approaches above, make sure you have the discipline to see it through. It takes discipline to continue saving and investing when you could spend the money instead. Also, if you need to pay off your debt as soon as possible to give you peace of mind, then by all means, do it.
Finally, remember that any debt you pay off is money in your pocket in interest saved—it’s a sure thing. Investing, on the other hand, is almost never a sure thing, even if your confidence level is high. Consequently, regardless of which way you go, assuming reasonable investment returns, you are doing something to improve your future net worth either way.
For reflection: When making financial decisions, such as whether to pay off debt or invest, remember that wisdom involves more than just math. It’s about aligning your choices with your values, your long-term goals, and the freedom and flexibility God desires for you. Do you balance prudence with faith and trust in God’s provision? Are you prioritizing peace of mind, stewardship of opportunities, or a mix of both? The verse below reminds us that debt can be a form of bondage, but wise stewardship, thoughtful planning, and disciplined investing can help break that cycle and build a foundation of flexibility and generosity.
Verse: “The rich rule over the poor, and the borrower is slave to the lender” (Proverbs 22:7, ESV).