Pay now, invest later, or invest now, pay later?
Debt repayment vs. investment.
This piece will be very general, but recently, I have seen a lot of talk about debt repayment versus investing. Many people have this idea that debt of any form is bad and should be paid down immediately before taking care of anything else. This mindset, although understandable, can oversimplify things and leave borrowers cheating themselves out of compound interest.
Now, some people are completely anti-debt. While this may not allow for a holistic approach to debt repayment, we all have to understand that our lives are not lived within a spreadsheet. But there comes a time when paying down debt in lieu of investing for the future begins to look pretty dismal when we consider longer time frames.
Debt repayment can also be heavily impacted based on what type of debt you are holding. A mortgage is different from a student loan. Why? Faster repayment on a mortgage could allow someone to accelerate the amount of equity they have in their home. This could then allow them to access more liquidity through things like a home-equity line of credit. Whereas paying down a student loan quicker is not going to “build principal” in any real asset.
Before we get started, this is not to say anyone should be making less than their normal repayments. This is solely focused on accelerated repayment schedules.
The sub-4 % debt:
It is very hard to make the case for an accelerated repayment schedule when the debt is below 4%. This could be student loans that were refinanced during 2020-2021 or a mortgage taken on during that same time period.
When we consider the risk-free rate of a 3-month Treasury Bill, we see that we are “net losers” in paying down the debt faster here.
Paying down the debt is an immediate and guaranteed return of whatever rate we have locked in. If the loan is at 3.5%, our accelerated payment guarantees us a 3.5% return.
Whereas we could earn ~4.377% in a 3-month Treasury Bill, which is much higher. I have seen so many people on social media let everyone know they are accelerating their mortgage payments with sub-4% mortgage rates.
Usually, they receive a lot of backlash. When your rate is below the risk-free rate, it is very hard to justify an accelerated repayment schedule.
5%-7% debt:
This is another range that makes it hard to justify an accelerated repayment, but there is a case to be made nonetheless.
While this is above the risk-free rate, it is still slightly below what we would expect a diversified portfolio to achieve over long periods of time.
If a diversified portfolio is targeting a 7%-9% annualized rate of return, it is easy to see how paying this debt down faster could be less than optimal. Especially when we consider the impact of compounded returns.
Even though the portfolio’s return may only be slightly higher than the debt’s rate, we know that subtle differences in rates have massive impacts on compounding.
For an easy example, check out the difference between a $10,000 investment that grows at 7% for 30 years versus that same investment growing at 8% over 30 years.
$10,000 growing at 7% compounded annually: $76,122
$10,000 growing at 8% compounded annually: $100,627
When debt ranges from 5%-7%, we really have to weigh the pros and cons of a guaranteed return versus the potential to exceed this rate of return over the long run with our investments.
Here is one scenario where I would highly encourage someone NOT to pay down their 5%-7% debt on an accelerated schedule:
Someone with student loans who is fresh out of school with a minimal cash reserve and no investments.
There is a lot of risk in that scenario. Without having a sound cash reserve built up, it is hard to make the case for an accelerated repayment. Paying down debt quicker does not offer this individual any assistance in the event they run into an emergency.
That can lead them to using credit cards or personal lines of credit to bridge the gap. It is always subjective.
8%+ Debt:
This is where we begin to consider accelerated repayment schedules. This is right in line with our long-term expected rates of return for our investments and nearly double the risk-free rate.
Again, from the 8%-10% range, we may not want to accelerate if there is a lack of cash reserves. Building a cash reserve is, in my opinion, something that can outweigh accelerated debt repayment. The 8%-10% range is high, but it is not necessarily toxic.
The 10%-30% range is where debt becomes toxic. You cannot out-invest these rates. These rates are usually associated with credit card debt. The national average for credit card rates is over 20%. This is absolutely toxic and needs to be addressed as quickly as possible.
Bonus debt content:
The same way inflation diminishes our real returns in our portfolio and “hurts” us, it “helps” borrowers and erodes debt. Think of what $1,000 could have gotten you 10 years ago versus what it could get you today. A fixed payment of $1,000 per month over long periods of time becomes less and less meaningful by way of inflation.
When thinking about the real rate of a mortgage, you have to remember the mortgage interest deduction. Given that this deduction can lower someone’s tax liability, it can be important to consider when thinking about the “real rate” of the mortgage.
For those who are tax-averse and have lower mortgage rates, this can further exacerbate the reasoning behind NOT paying down a mortgage on an accelerated schedule.