Should I Pay Off Debt Before Investing? Some Unexpected Results!

When I started investing, a very natural question arose; should I pay off debt before investing? I know that wealth and financial freedom can be achieved by compounding returns in the Stock Market, but debt is the opposite. Isn’t investing while you have debt like treading water? Or worse?

I set out to find the answer.

Short answer: You should invest and pay off debt at the same time.

When it comes to personal finance and investing, rarely is there ever a black-and-white answer. There is some gray when it comes to answering where you should prioritize debt vs investing.

To address the gray area to this question, I came up with 2 case studies that focused on high-interest credit cards (because we’ve all been there) and another case study based on an auto loan that had a lower interest rate. What would be the results of these studies if someone decided to focus on debt? Or invest and eliminate debt equally?

After reviewing the results, I found some unexpected insights between the two case studies that shaped my thinking around tackling debt and investing. I am confident that after you read this, you’ll be able to come to the same conclusion as me on “Should I pay off debt before investing”?

Biggest Factor in Deciding Debt Pay Off: Credit Card Interest vs Stock Market Return

Conventional wisdom would state that investing in the Stock Market while you have credit card debt is like taking one step forward, two steps back.

This is because of the difference between interest rates vs Stock Market returns.

The average credit card interest rate is 24.5%. This data was found in this Forbes article on the Average Credit Card Interest Rate.

When you compare to the Stock Market, the S&P500 has had a return of 11% since the end of WW2—data found at the S&P 500 Returns.

Just to hammer this point home, the graph below shows one of these is clearly bigger than the other.

You are digging a financial hole faster than you can fill it.

You can do both at once, but you’re delaying building wealth…right?

Is this really the case? Let’s focus on two case studies to find out.

Case Study #1 – High-Interest Rates on Credit Cards

With the assumption you already have debt when you start investing, how do you allocate funds towards paying off debt and investing at the same time? This first case study is an example of when you have debt with high-interest rates.

Case Study #1 – Bob wants to start investing. After monthly budgeting (Bob read my article on why a Simple Budget is All You Need), he determines that he has $600 per month to put towards paying off debt and start investing. Poor Bob unfortunately has $10,000 in credit card debt. Even if this credit card had a 0% interest rate and he paid $600 per month, it would still take him 17 months to pay all that off. Sadly, his credit card interest rate is 24.5%. Assuming he could get average Stock Market returns, we’ll be conservative and use 10%, let’s explore 2 options of what he could do.

To see which option is better, we’ll keep track of these metrics:

• Interest Paid: How much total interest was paid.
• How many months to pay off debt.
• Investment Portfolio Value after credit card was paid off.
• How many Months until Net Worth is positive (Net Worth = Invested Value – Credit Card Debt)
• Net Worth after 30 years (see how compounding makes a difference)

The last assumption would be, as soon as the credit card was paid off, the credit card payment would go towards investing. The full $600 per month would be toward Bob’s investment account.

Case Study #1 – High-Interest Rate Results

Before I give my insights and opinions on the results, let’s look at metrics.

First, months to pay off debt; clearly when you prioritize paying off debt first, it’ll take less time. The extra $200 per month knocked off 30 months’ worth of payments.

Likewise, if you pay more each month, ultimately you will pay less in interest. Paying off debt sooner results in $3,800 less interest paid.

At this point, when the credit card is paid off, we get some interesting numbers.

The total amount invested in the Stock Market plus its returns when the credit card was paid off, showed a drastic difference. In the 50/50 split, $21,297 is in Bob’s investment account, versus only $2,890 if he prioritized paying debt first.

Again, that makes total sense. The 50/50 split focused on getting his investments higher, whereas the Pay Debt First focused on paying debt sooner and paying less interest.

Case Study #1 – Net Worth Metrics

This leads us to the Net Worth metrics.

Bob’s Net Worth starts at negative $10k. This is true for both scenarios. And in each option, Bob is putting $600 towards decreasing that negative net worth. However, by prioritizing debt, which has a higher rate than investing, Bob gets a positive net worth 1 month sooner than the 50/50 split.

After Bob’s Net Worth is positive, it only takes Bob 4 more months to pay off his credit card debt when he prioritizes debt versus 33 more months in the 50/50 split.

In that 30 month difference where Bob has no debt, he can now contribute the full $600 to investing, versus the $300 in the 50/50 split.

The graph below is key. This graph shows us the returns from the Stock Market investments by month for each option.

We can see the returns are higher for the 50/50 split at the beginning. But once the credit card debt is paid off, and the full $600 is invested, those returns start gaining at a higher rate. High enough where at month 48, the Stock Market returns are higher for the pay-off debt option than the 50/50 split.

After the 48-month mark, the Pay off Debt option is having its investment returns gain faster than the 50/50 split, which ultimately leads to the Net Worth after 30 years being higher for the Pay Debt First option. While both options get to over $1Million Net Worth, the Pay Debt First’s option is $34,445 higher than the 50/50 split.

Case Study #1 – Summary

The case study around Bob’s dilemma on if he should invest equally or pay off debt first presents two options that lead to the same end result. As Bob stays consistent around budgeting $600 per month towards investing and debt, the long-term goals of investing are still achieved.

Here are a couple of key points of what we learned:

• Paying off debt first pays less interest
• Paying off debt first sooner by 30 months
• The time to have a positive net worth is nearly the same
• In the long run, Pay Debt First had a 3.2% higher return.

This Case Study focused on battling investing vs high credit card debt, but not all debt in high credit card debt.

Not All Debt is Bad

Before moving on to the next case study, we should focus on other types of debt.

While scouring the internet on whether you should pay off debt before investing, I found most answers were: “it depends.”

The reason many financial experts will say this is because not all debt is bad debt.

As mentioned above, the average credit card interest rate is 24.5%, but other debts, mortgages, auto, student loans, etc. are not that high.

As of July 2023, a 30-year fixed mortgage has a rate of around 7%. While that is high compared to recent years (in 2020 and 2021, these mortgage interest rates were near 2.5% to 3%) this still isn’t as high as credit card interest rates.

The question becomes, should I pay off my 7% mortgage before investing?

To answer this question, I’ll refer back to the credit card example, how does comparing a mortgage interest rate to the Stock Market return?

Adding the mortgage rate to our comparison graph, it seems more feasible to invest and pay off debt at the same time. It’s not the same as “one step forward, two steps back” like with credit card debt.

How Does the Length and Time of Debt Play a Factor?

I’ll also say, length and time do play a factor when considering paying off debt first.

In the case of a mortgage, which can be a loan of 15 or 30 years, you probably don’t want to wait 30 years to start investing. You’ll lose all that time for compounding interest on your investments.

An auto loan, typically 4-5 years in length, could have a similar interest rate as a mortgage, but much different length. In this case, you may be interested in paying off that auto loan first to allow those auto payments to go directly towards investing. This could be a prime example of Bob’s case study of, splitting payments equally towards debt and investing, or prioritizing debt first.

However, if the interest rate on the car loan is small, then there might be little to no difference in how you prioritize. Let’s review another case study.

Case Study #2 – Low-Interest Auto Loan

In the first Case Study, our fictitious character Bob, is focusing pay off high-interest rate credit card debt. Now let’s put Bob into a scenario with low-interest rates.

Again, we’ll use 2 different options as a comparison. This time, Bob has an auto loan of $25,000 with a 7% interest rate.

We’ll also be analyzing the same metrics for Case Study #1.

Let’s review the outcome.

Case Study #2 Results – 50/50 Split Wins!

Time to review the results!

Our metrics are shown below, comparing the 50/50 Split and Pay Debt First.

Unsurprisingly, it took less time to pay off debt and less interest was paid when Bob prioritized paying debt first.

Equally unsurprisingly, the amount invested when the auto loan was paid off was higher for the 50/50 Split.

And like the first Case Study, things get interesting when you look at our Net Worth metrics. The number of months, until Bob gets to a Positive Net Worth, is the same for each option at 20 months. This is equal because the auto loan interest rate is only a couple of percentage points lower than Stock Market returns. Even when you pay more towards the debt, since your Stock Market returns grow faster, you still reach that $0 Net Worth at the same time as paying off debt.

We can confirm this, by looking at our monthly Stock Market returns for both options.

Our graph below shows the monthly Stock Market returns.

The 50/50 Split is higher at first because more is invested each month compared to the Pay Off Debt First. However, when the Pay Off Debt First option pays off the loan (at month 28) the full $1,400 is invested each month. At this point, the rate of Stock Market monthly returns starts gaining on the 50/50 split. However, at month 41, the 50/50 Split pays off the loan and is now committing the entire $1,400 towards investing. After month 41, both the 50/50 Split and Pay Debt First are now gaining in the Stock Market almost equally.

The only differentiator between these two is now the 30-year Net Worth metric. The 50/50 Split at this point is $13k higher than the Pay Debt First. This is because those first 41 months of the 50/50 Split were building a slightly larger base to compound off of until the loan was paid off.

In the grand scheme of things, the difference in net worth is almost nothing. Only a 0.5% difference between the two options.

Case Study #2 – Summary

When investing, you should be focused on the long-term goals. While paying off debt is important, you want to be able to invest to one day gain financial freedom. In Case Study #2, focusing on debt that is less than the Stock Market returns, there is practically no difference in the long-term goals.

Here are a couple of key points of what we learned:

• Paying off debt first pays less interest
• Paying off debt first sooner by 13 months
• The time to have a positive net worth is exactly the same
• In the long run, the 50/50 Split return was only 0.5% higher.

Summary – So Should You Pay Debt Before Investing?

I initially thought that investing while you have debt was like one step forward, two steps back. In all reality, it’s one step forward…that’s it. You can invest and pay off debt at the same time.

The key is Balance. Clearly, you need to make your debt payments, that would be bad otherwise. However, you don’t need to ignore investing altogether. Putting off investing until 5…10…15 years is too long to begin with.

Based on the two case studies, our friend Bob, found that no matter the strategy he picked in tackling debt and investing, in the long run, the results were the same.

So that means, personally, what are your short-term goals? If both options get you to the same finish line, is it more important for you to….pay off all your debt? Be debt free? Maybe it’s more important to get that snowball rolling. Whatever is important to you, know that as long as you stay balanced and consistent, you’ll always end up where you’re meant to be.

Lastly, this whole exercise was based on the scenario that you are just starting to invest and currently have debt. While the math and numbers work, adding MORE DEBT in the future will greatly affect the outcome. This will slow your journey toward financial freedom. The solution? Emergency Fund. Please the 7 Reasons Why You Need an Emergency Fund to help ensure that your journey to financial freedom does not stall.

Thanks for reading! This has been a great exercise. Using numbers to address key questions like, “Should you pay debt before investing” can really help shape your path to financial freedom.

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Disclaimer

Levelzeroinvestor.com is not a registered investment, legal or tax advisor or a broker/dealer. All investments / financial opinions expressed by Levelzeroinvestor.com are from the personal research and experience of the owner of the site and are intended as educational material. Although best efforts are made to ensure that all information is accurate and up to date, occasionally unintended errors and misprints may occur.