Should I Pay Down Debt

Have you ever asked the question; “is it best to try and pay down my debt or invest for the future?” Dave Ramsey would likely have you believe that the answer is always pay down the debt. However, the answer is generally less concrete and more of the “it depends” variety. In my years as a financial planner, I’ve been asked this question numerous times. This blog post will hopefully help steer you in the direction of the right answer for you. However, it truly does depend, and it’s important to remember that this post is generalized so you still need to consider your individual situation and work with the appropriate professionals if necessary.

The Numbers

Before getting into the qualitative parts of this decision let’s look at the math. The scenario I ran is for Grant who has a $400,000 mortgage, with a 25-year amortization, payments of approximately $2,167 per month and interest rate of 4.29%. He has an extra $6,000 to either invest in an account earning an assumed return of 7% annually. Alternatively, he can allocate the $6,000 each year to pay down his mortgage faster. In both scenarios after he finishes paying off the mortgage, he will invest the now unallocated $2,167 to his investment account earning the assumed 7%.

The math of this scenario shows a slight advantage to investing the $6,000 each year instead of paying down the debt. As the tables below indicate, investing instead of paying down debt results in a higher portfolio value after 35 years and a higher net worth albeit with a higher total interest paid expense.

Comparison of portfolio values for the person who elects to contribute nothing to investments and focus on paying down debt versus the person who continuously contributes to their investment portfolio.

Comparison of total net worth for the person prioritizing paying down debt versus investing. (Accounts for home equity and investment portfolio only)

Finally, a comparison of the interest paid on the home purchase for each person.

As I mentioned previously there is a slight advantage to investing versus paying down debt but in this scenario it’s really close. That leads me to the second part of the consideration around this question, which is the qualitative factors. In some scenarios, the calculations above show a clear winner one way or the other that would be hard to dispute. However, sometimes it’s the qualitative factors that drive the decision.

Qualitative Considerations

Your personal feelings towards debt, comfort level with investment risk, time horizon, expected investment return, commitment to investment strategy, spending habits and need to maintain flexibility all contribute to the decision around investing or paying down debt. These types of behavioural and psychological areas are important to consider just as much as the math. A proper financial plan is one you can stick to for the long term and if it doesn’t match your behaviours and emotions it’s likely to fall by the wayside.

Personal Feeling on Debt

Some people are comfortable using debt, paying interest and knowing they have liabilities owing, assuming they feel it is moving them forward (i.e. good debt). While others try to limit debt as much as possible and would sleep better at night knowing they don’t have any liabilities. Everyone’s comfort level will differ and it’s important to consider what yours is when deciding to invest or pay down debt.

Expected Investment Returns

An important piece to both the math and the behavioural parts of this decision is what we can reasonably expect for investment returns. The general thought is if you can earn a higher rate of return on your investments than the interest you pay, do the investment. But that can be tough to predict and as we saw in the example above, a long-term plan that allocates the mortgage payment to investments after it’s paid off helps narrow the gap considerably. The expected return on your investments is also very closely tied to your risk tolerance and corresponding investment choice.

Comfort Level with Investment Risk

If you are comfortable taking on investment risk and have done a risk assessment where most of your portfolio will be growth based, you should be able to assume higher expected rates of return than someone who is low risk and concerned with safety. The low-risk investor may predominately use tools like GICs to grow their capital safely but with lower expected rates of return. If in our example above with Grant his rate of return on average was 4% each year instead of 7% the math would support paying down debt instead of investing. Grant would have a higher net worth and portfolio value in 35 years after focusing on paying his mortgage off.  

Time Horizon

Time horizon is often overlooked when making this decision, but it is an important factor to consider. In the given example, Grant had 35 years to retirement and a long-time horizon to save, invest and take advantage of compounding returns. If for example he only had 20 years instead of 35 he would be better off building more significant retirement assets through his investments. Of course, this requires more in depth planning and other questions answered, but it illustrates the point of how a person’s time horizon matters.

Investment Strategy and Spending Habits

Long-term strategy and spending habits have a major impact on which option will be best for the future. If a person does not take a long-term approach with their investments, buys and sells frequently or flip flops between income and growth producing, the impacts to the portfolio will be very meaningful. Likely not in a positive way. In addition, if someone is a spender and not a saver/investor they will likely have difficulty allocating enough money to future savings and should do as much as they can as soon as possible.

Using the above example again, Grant decided to put 100% of the mortgage payment into his investment portfolio as soon as the mortgage was paid off. This may not be possible for some people, while others may prefer to not do that at all. With the variables changed to either simply maintaining $6,000 per year of total investment or only half the mortgage amount ($1083.50/month) allocated to investments the choice of prioritizing investment versus paying down debt is skewed much heavier toward investing opposed to paying off debt.

Flexibility Requirements

A priority of financial planning at MC Wealth Management is maintaining flexibility whenever possible. Life can throw curveballs, and a solid plan will have the ability to adapt as needed. Both paying down debt and investing have similar impacts to short term flexibility, although one may be slightly preferable. If you were to invest, depending on the account type you choose, you likely would have easy access to funds should an unexpected expense arise. Alternatively, if you were to pay down debt and needed cash, you could take out a loan against the equity in your home (or asset that you’re financing). This is a viable option although you run the risk of potentially paying higher interest and it would probably take longer to receive the funds. It also defeats the purpose of paying down debt, just to take it out again.

In terms of long-term flexibility, I generally consider the edge going toward investing. It builds up a base level of a nest egg or retirement income while it is controllable today instead of pushing the bulk of these savings to the future and the unknown. For example, say Grant was laid off from his job and took a serious pay cut in year 20 just as he started significantly investing after paying his mortgage off a year and a half earlier. He likely cannot allocate the same amounts to his investments and will either need to retire on less or work longer. What if while he was off work he needed funds to supplement his lost income and had to take out a Home Equity Line of Credit thus bringing back the debt he had paid off. Alternatively, if he had been investing he could have simply withdrawn from his account as needed during unemployment and continued growing assets for retirement on the remainder without increasing his debt level.

Conclusion

To wrap up, the answer to the question of paying down debt or investing extra cash is generally not easy and there is no real right or wrong answer. Instead, it depends on a large combination of factors that should be considered altogether. At the end of the day both options are responsible and should be regarded as good financial decisions. Like most decisions it’s about considering the trade-offs and what is going to be most optimal for you both now and in the long term.

At MC Wealth Management we help our clients with their financial planning and provide answers to questions like paying down debt versus investing. If you would like to experience the same benefits of working with us and experience the help we provide, reach out however you prefer through one of the methods below.

Phone: (306) 873-9273

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