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There are two sides to each argument. When it comes to the invest-versus-pay-off debt debate, we land pretty safely on the paying down debt side, but with a firm balance on investing. The reason is that being debt free provides several benefits. Here are a few:
1. The freedom of getting out from underneath the burden of debt is hard to quantify but cannot be overstated. Each debt you pay off is one less mandatory expense that would be necessary should you fall on rough times. The psychological benefit of being debt free is also significant.
2. You save yourself the interest you would owe on the debt by paying it off early. Once your debt is gone, you can then use the money you were putting towards debt invest and build wealth.
3. Paying down debt is a guaranteed return on your money, but returns in the market are never guaranteed. Some people would rather leverage their debt by investing in stocks and hope to get 8% per year rather than pay off loans with a 5 or 6% interest rate. It's OK to do that, as long as you recognize that there is risk involved.
While there are very real benefits to paying off debt, math is still involved when it comes to the question of paying off debt versus investing. This comes down to the various breakpoints to categorize what is considered high, medium, and low-interest debt.
Interest Rate Break Points
There is an interest rate break point where paying off debt begins to outweigh investing due to the guaranteed nature of the interest rate when paying off debt. For me, this number is 4-5%. It may be slightly higher or lower for you.
Said differently, when your debt climbs north of 5% interest, it is common wisdom to target your debt instead of choosing to invest and hope for an at-risk return of more than 5%. We could argue what that number ought to be, but either way, if you are paying down debt or investing you are winning at the game of personal finance. Both of these options are better than spending the money.
A Quick Note on Student Loans
For the 75% of readers with student loans, another point worth considering in our conversation of paying off debt versus investing is to determine whether you are in the Public Service Loan Forgiveness camp or the Pay It Off camp. To do this, the Debt to Income Ratio (DIR) tool is helpful. To calculate your DIR, divide your student loan total by your expected annual income as an attending physician. Broadly speaking, this breaks down into two groups:
-A DIR of > 1 should push you to consider PSLF.
-A DIR <1 can go either way (i.e. pay it off yourself or pursue PSLF)
Note that the DIR is a rough tool. To figure out how much PSLF could be worth for you, schedule a consult with an Attend Student Loan expert.
Paying Off Debt Using the Investing Waterfall
Here are the general guidelines for choosing whether you should pay down debt or invest. We call this the Investing Waterfall because as you fill up each step, the cash flow (i.e. water) falls onto the next step. At any point in this waterfall if you get to the point that you are meeting your annual savings goal (i.e. saving enough each year to retire by the age you want), then you stop investing. Remember, your annual savings goal is determined by working backward from how much you will need in retirement (25 to 30 X your annual expenses) and determining how much you need to save each year to get to that goal by the age you want.
Once you surpass your annual savings goal, you can choose to spend any remaining money or to pay down any remaining low-interest rate debt <5%.
Note: The following should be seen as general guidance and education. You may elect to break up these interest rate break points differently. For example, you may feel that high-interest debt is anything above 8% as opposed to the 10% breakpoint we illustrate below. Regardless, the structure of this framework should prove helpful. Here is a primer on various investing accounts, should you want to learn more.
The Investing Waterfall
1. Contribute enough to receive your employer match inside of your 401K/403B
2. Pay off any high-interest debt > 8-10% (e.g. credit cards, consumer debt, etc)
3. Max out the remaining 401K/403B for both you and your spouse, if married. Pre-tax is preferred during peak earning years and also lowers monthly payments for those pursuing PSLF.
4. Calculate your DIR and determine if you will pursue PSLF or not.
5. If paying back the loans yourself, make a plan to pay them off in 3 to 5 years, particularly if interest rates are >5%.
6. If pursuing PSLF, make the minimum monthly payment and move on to the next steps.
7. Pay off any non-mortgage debt with an interest rate >5% (e.g. car loans, private loans, etc)
8. For those who need to save additional money to meet your annual savings goal, the following should be considered in order:
- Max out your Health Savings Account (HSA) if you have a high deductible health care plan, and you do not have any large recurring or expected health care expenses that would not make an HSA advisable.
- Max out any governmental 457 for you and your spouse, if married.
- Max out your backdoor Roth space for both you and your spouse, if married.
- Consider using a non-governmental 457, if appropriate.
- Any additional money can be placed into a taxable brokerage account.
9. Pay off any remaining debt <5% including your mortgage
Take Home on Investing versus Paying Off Debt
Utilizing the above waterfall, you can see that the decision to pay off debt versus invest is based on interest rate break points. We recommend considering anything above 8-10% to be high-interest debt, debt between 5-8% debt as medium-interest debt, and anything less than 4-5% as low-interest debt.
However, the mathematics of interest rate break points must be weighed against the very real psychological benefits of paying off debt. For this reason, feel free to adjust your interest rate breakpoints or steps above. Personal finance is personal. That said, if you follow the framework above, it should get you to the financial goals you are working to achieve.
