You, my dear reader, are probably working on your financial independence. You have some leftover money in your budget, and are now wondering. Should I pay off debt or invest my money in the stock market or real estate?
A lot of people will shout PAY OFF DEBT! But of course, not all debt is bad. Some debt is good, because it enables you to do things you otherwise wouldn’t have done, such as buying a house.
Other people will say that investing is the only option. They walk a very fine line between paying their minimum debt service and going bankrupt.
Both camps have valid points here. That’s the problem. Which believe system, which strategy will you use to become financially independent? Let’s take a look at a couple different opinions.
Dave Ramsey is the author of “Total Money Makeover” and he is firmly in the no-debt camp. He advocates paying down debt aggressively using the debt snowball method where you tackle low balance debt first, then move to the next smallest balance all the way until you have paid off all non-mortgage debt.
Ramsey is very good at motivating people to get out of debt. What he does is fantastic, but it’s not for everyone. For people who have difficulties managing their money, Ramsey’s advice is solid. In my opinion, other people might take a different stance and be less aggressive when it comes to paying down debt.
Sam – Financial Samurai
Sam from Financial Samurai came up with his own system regarding the question of debt vs investments. It is called FS-DAIR, or Financial Samurai’s Debt And Investment Ratio. It is a more scaleable approach to paying down debt than Ramsey’s method is.
In Sam’s system, you pay down loans in order of interest rate, highest first. You multiply the interest rate by 10, to find your allocation of money towards that debt. If you have a 5% loan, you’ll allocate 50% of your monthly savings amount towards that debt, and invest the other 50%.
All loans over 10% are toxic (I agree) and should be paid off as soon as possible. They warrant a 100% allocation. If you have multiple loans with varying interest rates, the system is easy. Say you have a 16% credit card, a 9% personal loan, and a 2% student loan. You will then allocate every euro you can find towards paying down the credit card. Once that loan is gone, you start using 90% of your monthly savings rate towards the personal loan while investing 10%. As soon as that one is gone as well you bump up your investments to 80% and use the remaining 20% to pay off your student loans early.
The Good, Bad, and Ugly
So I really like what Ramsey’s doing for people just starting out with personal finance, and getting out of debt. However, he can be a little bit too much for my taste… I do think there’s good debt. Paying off totally good debt is not something one should aim for when you’re young. At least not with everything you have.
In my opinion, it’s way better to have a sizeable investment portfolio, next to having a bit of good loans like low interest mortgage debt. My strategy for prioritising investing over debt payments therefore is easy.
When the debt is high interest or generally considered “bad” (such as short term consumer loans) I would put everything I had towards paying that down. If the debt is low interest, long term like a mortgage, I would probably keep it and invest.
So, Pay Off Debt or Invest?
The problem with my system is the definitions. That’s what I like about Sam’s FS-DAIR system. It’s simple, but formula-based and it’s got a gliding scale. However, I think it should be capped both on the upper and the lower end of the spectrum.
Let’s start with the lower end of the interest rate spectrum. I don’t feel excited about paying 20% of my monthly savings rate towards a 2% mortgage. Especially not at age 25. At age 25 I should be investing like crazy. Both in the markets (shares, property) and in myself.
Also on the high end, I’m not that happy about a 8 or 9% interest rate on a personal loan and not giving everything I have to paying that off. We know the long term returns in the stock market are around 7-10%. I would choose an 8% guaranteed return on my money over 7-10% with a lot of ups and downs any day of the week.
So I came up with a slightly modified version of the system myself.
Introducing My New System
Let me introduce to you Fire The Boss – Debt and Investment Ratio (just joking, I wouldn’t steal this term from Sam). The FTB system would follow Financial Samurai’s general glide path, but introduces a cap to the lower end of the spectrum, and arrives at a 100% allocation sooner than you would with FS-DAIR.
So when you want to decide to pay off debt or invest, take a look at the table below.
|Interest %||Allocation %|
The formula to find your debt allocation is 20 x (interest rate – 3%).
Implementing the System
So now you know what to do with paying off debt and investing. Depending on the interest rates on your debt, you will either invest more and focus less on debt or vice versa. I’m a big believer in investing big, but when you’re under the stress of a lot of debt it is better to pay this off early.
I modeled this system against my own beliefs and it is in no way financial advice. Please always do you own research and make your own decisions.
In practice, this system for me means that I do not pay off any additional funds towards my mortgage since it is at 1.40% before tax deductions. In the future this might change.
For example, when Girlfriend and I move to our forever home, we might opt to pay it off in 15 years instead of 30. That’s partly because during that time we want to become financially independent. When you want to retire it’s best to keep your cashflow obligations low, so paying off your mortgage is considered good practice even though your money can yield more elsewhere.
For now, I will keep my focus on investing more rather than paying off my mortgage.
If you want to pay off debt, what strategy do you use? The Snowball or the Avalanche?
Do you pay off debt or invest, or both? Let me know in the comments below.