fbpx
Pay Off Debt or Invest For the Future?

Pay Off Debt or Invest For the Future?

Often people ask me whether they should pay off all debts before saving for the future or save first in hopes of earning a higher return on investments than they are paying in interest on debts. This is an age-old debate, and I have heard convincing arguments from Financial Advisors on both sides.

The “Pay Off Debt” Argument

Some advisors recommend that we liquidate all of our savings and investments except a very small amount, even as low as $1,000, to immediately pay down as much debt as possible. Then they recommend that we use every discretionary penny from each paycheck to eliminate the remaining debts as quickly as possible. After we are completely debt-free, then we can start saving and investing for the future.

I admire people who are disciplined enough to follow this extremely aggressive strategy, but it is risky because it does not leave an adequate safety cushion. A $1,000 savings account would not be enough to cover unemployment, major unexpected expenses, or serious extended illness. What would happen to my house if I could not make my mortgage payment for six months due to unemployment? Would the bank cut me any slack because I had been paying them extra for the past year in hopes of paying my mortgage off sooner? Not likely. We should always maintain at least three to six months of living expenses in liquid savings, even if we have debt.

The “Invest it All” Argument

On the other extreme, some people recommend borrowing as much as the banks will allow and investing it all because they declare we can make more on our investments than the banks will charge in interest. Is this true? Can we really make more than what the bank is charging us? Yes, sometimes we can, but how consistently?

This philosophy is part of what caused the real estate, banking, and stock market meltdown of 2008. Before the crash, banks were willing to lend up to 20% more than the appraised value of homes. People were pulling out all of this “equity” to buy more houses on credit, invest in the stock market, or just spend it, because they thought the value of real estate would always continue to increase as it had for many years. It is obvious to everyone now that this was not sustainable, but it was not obvious at the time. Millions of people lost a lot of money as a result of this practice, and some people lost everything.

The practice of excessive borrowing to invest is part of what caused the Stock Market Crash of 1929 that preceded the Great Depression, too. A myriad of ordinary people who did not fully understand the risks involved were buying stocks on margin, which means they were borrowing money to buy stocks they could not afford to buy on their own. Partially as a result of so many people buying stocks on margin, the already inflated value of the stock market was artificially pumped even higher during the late 1920s.

When the market started to fall, the margins were called, which means these investors were required to immediately pay the loans back in full. Since most people could not afford to repay these loans, they were forced to sell their stocks to meet the margin calls, which drove the already declining stock prices into a rapid downward spiral. History has taught us that maxing out our debt to invest can be very dangerous for individuals and for society as a whole.

A Balanced Approach to Saving and Debt Reduction

I do not advocate either of these two extremes, but rather prefer a balanced approach. First of all, we must be careful not to become so obsessed with paying off debts or building assets that we neglect the other critical areas of taxes, tithing, protection, and maintaining adequate liquid savings. After we have acquired adequate insurance and enough liquid savings to cover three to six months of living expenses, our first priority should be to pay off high-interest short-term consumer debt such as credit cards or car loans, maybe even before investing at all. We can never get ahead financially if we consistently earn 6% on our investments while paying 18% interest on credit card debts.

After paying off all high-interest debt, we would be prudent to build assets while gradually paying off any remaining low-interest, potentially tax-deductible debt such as mortgages and student loans. Why not pay off all debts first? I have seen too many people fall into the trap of thinking that reducing debt is the same as building assets. In reality it is just making up for past overspending, unless the debt was incurred to buy assets, such as rental real estate. They think they are making financial progress by paying more than the minimum due each month. However, once they are debt-free they discover that they can afford an even bigger house, nicer car, and more toys, all of which are much more exciting than investing for the future, so they incur more debt and the cycle starts all over again.

After a few of these cycles, they arrive at retirement age wondering what happened to all those years of sacrifice to aggressively pay off their debts. Now they have nothing to show for it but memories of old cars, boats, and houses that are long gone because they were never really building assets. They were just playing a never-ending game of catch-up from former overspending.

Another reason to build assets while paying down debt is that putting everything towards debt elimination can be discouraging, especially if it is going to take a very long time to completely extinguish all debt. Conversely, seeing our assets increase while our debts are decreasing is motivating.

Building liquid assets also increases our overall safety and liquidity so we can continue to meet our obligations if our income decreases dramatically for an extended period, as in the example of unemployment we discussed earlier. If we do not have assets to tap into when times get tough, paying extra principal on a mortgage or student loan can actually be a very risky place to put money because those extra payments can never be taken back out. The extra payments do not benefit us until the loan is paid off completely. We could be making extra principal payments for ten years and then lose our job, yet the amount due the very next month would be the same as if we had never paid any extra principal. Therefore, it might be wise to continue building assets while paying down low-interest debt over time for psychological and safety reasons, even if it does not always make sense mathematically.

 

Adam Dawson, CFP® is a Principal at Capstone Capital and the author of Timeless Principles of Financial Security.

 

Adam Dawson
[Sassy_Social_Share]

Similar Articles

Similar Articles