Should I Pay Off Debt or Invest?

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?

Different Opinions

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.

Read more on investing here.

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

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.

I even took out an additional mortgage to 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.

Your investor policy statement should include whether you want to eliminate debt or invest instead.

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.

10 thoughts on “Should I Pay Off Debt or Invest?”

  1. I think this question is easier to understand when you take “consumption” into account. What’s better? Investing, consumption or paying off your debt? If you invest, then normally you get more money in return (on the long run). When you consume, you don’t get your money back and when you pay off your debts, you can’t use that money for new investing or new consumption.

    • Hi Fred, thanks for your reply! I disagree that consumption should be taken into consideration. Because if you choose to consume instead of save/invest/pay loans, your balance sheet actually declines. Your balance sheet does not decline when saving/investing/paying off loans. So the actual question is to consume or not. When you don’t consume then the question to invest or pay off loans comes into play.

  2. Love the new site and redesign. Cool to see that you also switched to English.

    I think that one should not have any debts besides a mortgage. Eliminate debt, build emergency and start investing. That would be my order of business.

  3. I find when talking to people about debt(mortgage) vs. investing, that their attitude tends to lean towards paying off your debt(mortgage) as fast as you possibly can – but it varies a little, the younger they are.
    People in their 40s or 50s still remember when the interest rate was 20%.

    I’m 35, and my first mortage was around 5% interest rate. It’s only been going down from there, and I’m currently paying 0.5% (flex-mortage, 3-year fixed interest intervals).
    Most of my friends have fixed 3%+ mortgages, and I understand why they would want to pay off their mortgage fast, rather than use the excess cash to invest. The big question here is, where the interest rate is going to be in 3-5 years. Nobody knows.
    If you’re sensible, you’ll expect the interest to once again climb back towards 5%. If you’re a risk taker, you won’t ever expect it to reach 5% again. I’m somewhere in between.

    I’m currently leveraging my mortgage payments (to use the money to invest instead), and I only pay off my mortgage 3/4 of the year. Next year I plan to lower it to 1/2. I owe about 75% of what my house is worth. Ideally, I would like to get it below 50%, and then stop paying it off altogether (convert to an interest-only loan). Perhaps that is risky, I don’t know. It all depends on where the interest rates goes from here I suppose. Considering the worlds massive debt, I honestly find it difficult to believe that the interest levels should double from their current levels – but who knows. It all depends, how much risk you’re willing to take. As my investment portfolio grows, my risk exposure towards the interest rate will automatically drop. Once my portfolio is worth the same amount as I owe in my house (mortgage-neutral), I really don’t see a reason to pay it off at all (as long as my interest rate remain below the inflation level…).

    I think you need to also factor in your equity (somehow) in your system. – But I’m only thinking in terms of mortgages – I’ve never had any other kind of debt, and I find it hard to understand why people would borrow money to buy depreceating assets at outrageous interest rate levels.

  4. Great article. What is your opinion on student loan debt? Do you consider this to be more like a mortgage-kind of a debt or should you try to pay it off as quickly as possible?

    • Depends on the interest rate and more. If you want to buy a home in the near future and need the maximum mortgage, sometimes paying off even a low interest student loan makes sense. But as always, I’m not a financial adviser so do your own research.

  5. Interestingly, my opinion on this topic changes over time depending where I am in my life’s journey.

    Initially, when just buying my first home, it felt like a huge commitment. And I totally wanted to get rid of it asap. I considered this an unsustainable emergency. Yuck!

    It made me realise how much my freedom is worth to me – I put it above being efficient.

    So, I took up a mortage that would require me to linearly pay it off and I took a variable rate – why not, I was going pay it off fast anyways – and that way I could keep my options open to pay it off even faster without penalty.

    Then some months into it, I changed my mind a little, if I pay it off that agressively, life is no fun.. and this is going to take a while.

    My freedom to me also means being relatively free from decisions made by past me, atleast ones that future me might not approve of.

    So, instead I kept paying off linearly and started investing whatever felt ok. I can still one day decide to pay off the mortgage and I could do that even faster, if the market is doing well at that time.

    For a while it was fun to watch my mortage debt get destroyed every month, and the monthly interest go lower and lower both due the lower principal as well as lowering interest rate due to the variable rate.

    But that got boring and then wore off when instead I got annoyed that all that money is going into the bricks.. not even thinking about the potential value of my house that was stuck in there due to appreciation.

    So, I think it’s really cool that you’ve pulled money out of your house here in the netherlands, it’s something that seems more commonplace in the US. I considered that before but never actually dived deeper into it. The market is excellent to refinance for that at the moment.

    Paula Pant at Afford Anything makes it seem common practice as a rental realestate investor to occasionally do a cash-out refinance to keep it at a 50% allocation, after some period of inflation. By the way, I highly reccommend her podcast as youy’re intestested in rental income. She’s recently put a course out to get started as a realestate investor. it’s geared to the US market and doesn’t consider out of country investors (but it does consider out of state investors which sort of is the same thing).

    I might even consider a lower allocation than 50%, considering how relatively less risky the dutch housing market is in comparison with the US. Especially if you’re also the occupant of the home. Ideally, we should be able to play with this depending on where we are in life. Unfortanately, it’s hard to get a good mortgage past 75, and I’m planning to get way older than that.

    I’m still unclear about the end game scenario, there is no point in using the 4% safe withrawal rate to determine what you need have in stockmarket in order to pay off the mortgage and the interest on it, if you plan on paying it off. With the mortgage being a fixed numbe, and the interest rate can be fixed as well, paying it off does not require considering inflation. So why not simply pay interest only or set something aside that will accumulate to paying off the mortgage to a ratio that’s acceptable.