Pay off debt or invest?

by Manshu on October 9, 2009

in Opinion

I saw this question over at Five Cent Nickel couple of weeks ago, and it reminded me of the mistake I had committed a few years ago. At that time I invested in the stock market with money I could have used to pay off my credit card balance.

That was clearly not the right thing to do because the returns on the stock market aren’t predictable, whereas the interest on a credit card is really quite high, and knocks home every month.

I continued investing while not bringing my credit card balance down because I believed that the stock market was very low, and paying a little extra in credit card interest won’t harm me as much as passing the opportunity of investing at those levels.

Eventually I realized that the market was going nowhere but my credit card balance was heading north every month. I stopped, and paid off the credit card before investing again.

There is absolutely no doubt in my mind that paying off a credit card balance is much better than investing in the stock market.

Credit card debt is not the only debt though, and stock market is not the only place to invest. That’s what makes this question interesting.

Over the weekend I searched through all the personal finance blogs on my reader, and found that a lot of them had addressed this question.

I thought I’d present what I felt was their most important argument as a snippet here. I strongly recommend that you read all the posts also. It shouldn’t take more than half an hour of your time, and I am sure most of us will need to address this question at one time or the other.

Nickel from Five Cent Nickel: Pay off debt or invest?

Developing a strategy

Here’s a thumbnail sketch of how I’d approach things. Note that for the first step, I’m assuming that you have enough to cover all of your minimum payments plus make the 401(k) investment. If not, you should obviously focus on your debts.

  • Invest enough to get your 401(k) match
  • Pay off all non-deductible, high interest consumer debt
  • Jump back on the investing bandwagon

Trent Hamm from The Simple Dollar: The Constant Tug: Should I Invest or Should I Pay off Debt? (this post is a couple of years old)

Spend less than you earn, then do what seems right for you. You’re not going wrong by paying off your debts quickly, or keeping debts while investing rationally. In both cases, you’re still sticking to that central idea – just spend less than you earn.

Jim from Bargaineering: Pay More Mortgage or Invest Wisely?

Yes! You can potentially earn more money by investing your money in the stock market than paying down your mortgage. I totally agree. So why did I tell people that they can save a ton of money by paying down their mortgage when they could make more by investing?

I wrote that because one of the fundamental principles of prudent investing is diversification. The stock market doesn’t return 11% year in and year out, it returns that average over many many years. With your mortgage, that return is guaranteed.

Dough Roller: Should you sell investments to pay off credit card debt?: I won’t quote from this article because DR has presented some options and things to consider, and they are going to be different for different people. So, I think it a bit risky to take any one part of post and present it here, lest it gets badly out of context.

SVB from The Digerati Life: How to invest in the stock market?: I won’t quote from this article either, but in general, the theme is that credit card debt should be dealt with first before investing in the stock market. Also, SVB is generally averse to debt and would deal with that first before anything else.

Matt Jabs from Debt Free Adventure: Should I invest while still in debt?

Investing while still in debt is usually not a wise strategy because it is likely that you are paying more in interest on debt than you would earn in interest on investments.  That is not always the case, but it is the most common case.

Conclusion

The theme in all these snippets is that there is no right or wrong way of dealing with this question. It depends a great deal on your personal circumstances and your goals. Not all debts are equal and that is true for investments also. It’s better to get rid of something like a credit card debt before investing, but it is okay to have a mortgage which will eventually translate into a hard asset, while you invest.

What are your thoughts on this? I am especially interested if you think there is a particular situation in which it absolutely makes sense to invest while you are still in debt.

{ 9 comments… read them below or add one }

Jessie October 9, 2009 at 11:26 am

I agree with you here – paying off your consumer debt should be priority number one.

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Manshu October 9, 2009 at 2:21 pm

As your regular reader, I am quite familiar with how passionate you are about getting rid of your debt. It’s really commendable!

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Unfair Contract October 9, 2009 at 3:51 pm

I always tell clients that there is good debt and bad debt. But I would always recommend having NO debt and deal in cash and gold.

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Nash | nil2million October 9, 2009 at 11:12 pm

Hi Manshu,

I totally agree with you. In Malaysia, the credit card interest rate is 18% p.a.

unless ure incredibly lucky, that’s hard to beat or sustain in the market.

It’s great financial practice to settle ur credit card debt first.

Nash

Reply

Manshu October 10, 2009 at 11:13 am

Yeah with rates that high, it is impossible to beat the market. Gotta get rid of that credit card debt first for sure.

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Chirag October 25, 2009 at 7:29 pm

A very good post!
Helpful 🙂
Your personal views are always so good !

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Manshu October 26, 2009 at 5:08 pm

Thank you Chirag.

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Ruchi November 28, 2011 at 2:04 am

What if you invest in debt instead of p aging home loan because you get the tax benefit too. Is that a wise financial decision ..?
Manshu, you expert comments will be most welcome.

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Manshu November 28, 2011 at 5:33 am

You have to compare how much tax you save versus how much your overall loan payment will shorten to find out.

I think someone who pays a lot of interest as part of their EMIs and is in the early stages of their loan is better off by paying off the loan because that will apply to the principal and reduce the duration of the loan or the EMIs but someone who is at the stage where the principal forms more of their EMI – they will probably benefit from the tax saving aspect of this.

There won’t be one answer for everyone, it will depend on how much of the loan is left, at what interest rate and what is the tax bracket of the individual Ruchi.

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