Pay down debt or invest

There’s a debate you read often on personal finance blogs: if you have a large sum of money, should you use it to pay down debt or invest? The answer is usually dependent on the person’s risk tolerance, but I think it also depends on the nature of the debt.

Debt is a bad thing in most cases. Something you “own” like a house is actually not owned by you. The house is owned by a bank. The bank is just letting you use it. Why? Fail to pay for a month or two, depending on the mortgage terms, and the bank will take back the house. The bank can’t just take 1/360^th of the house back for each month you miss, so they will repossess the whole thing and the law will be on their side. To me, this means the bank owns the house.

However, there are better kinds of debt; take a student loan. If you pay for your education with a loan, it can’t be taken away later. You will have that diploma and although you can have your credit rating wrecked or your wages garnisheed by failing to pay that debt, you’ll always have that education. That’s quite different from using debt to own things.

Now if you have credit card debt, pay it down before you spend a dime on almost anything else in your life except maybe health insurance. Any debt where you pay 18%+ in interest is bad debt.

In comparing debt to investing, no investment in anything, ever, is guaranteed. We could plunge into a 20-year depression in October of this year. Unlikely, but the US has a number of unfavorable situations that could cause this to happen, so it is not impossible. If that happens, all of my index funds and money markets won’t be worth much. Investing has no guaranteed rate of return, and in fact can have a negative rate of return quite easily. If you bought Enron stock, your net return was -100%. If you have a stock paying 2% dividends per year with a stagnant price per share, you are not doing as well as you could parking that money in a high-yield savings account.

However, if you can pay down debt you have a guaranteed rate of return. If I have a 5.6% mortgage (I do, lucky me), then every bit of principal paid early is a reduction in the amount of interest I’ll eventually owe. Once that payment’s in, that interest is gone. This makes wonderful sense for something you want to ‘own’, like a house. However, if you look at my student loan example, what’s the advantage of paying early? Nothing, really. I already fully “own” the asset (my knowledge and diploma).

To sum these examples up, what really matters is ownership. If you can pay down debt to own something, I think that will beat investing any day. Sure, the investment might return 11% per year for 15 years. However, it might not, and many, many students of the market have been burned trying to beat it – better students than I. So I think the goal is to look at whether paying down debt increases your “true” assets or just stifles your cash flow by hurrying up payments for something you already own.

So that’s my opinion in the debt vs. investing debate. It does depend on the individual, but I think I would rather be debt-free and investment-poor than highly leveraged with a huge portfolio. If that was a smart idea, people would be using their home equity loans to invest in the stock market, right?

Tags: health, investing, life, money, saving