Investing vs Paying Down Student Loans & Debt (Part 2)

In the first part of this article, I discuss the issue of whether to use your leftover income after living expenses to pay down debt or to invest.  The key to answering this question was measuring opportunity cost – how much does it cost to either not pay down my debt or invest?  In other words, if your credit card has a 25% interest rate and you think you can earn 7% investing, you’re probably better off paying down your credit card.

We also discussed the effect of taxes when comparing holding debt versus investing.  Specifically, certain types of interest payments are tax deductible (mortgages, student loans, etc).  Therefore, the cost to hold tax-deductible debt is cheaper than your actual interest payments since you’ll receive a bigger refund come tax time.

In the second part of this article, I want to discuss two other factors worth considering – investment risk and retirement plan matches.  I also created an easy-to-use calculator to help you make your own decisions.  You can download it by clicking here.

Image of the spreadsheet calculator I use to compare the opportunity cost of investing versus paying down debt.
Here’s what the calculator looks like once you download it. Directions are in the green box!

Investment Risk

Here’s what we know about paying back debt, it’s a virtually guaranteed cost.  Unless you have a relatively rare variable rate loan, your interest rate on your mortgage, car loan, and student loans are most likely fixed.  Therefore, if your car loan carries a 7% interest rate, you can assume it will stay at 7% until it’s fully paid off.  From an investment standpoint, I framed paying off debt in terms an investor would describe it.

“I have a $10,000 car loan at 7%.  I am guaranteed to pay 7% every year.  Therefore, paying off the debt is equivalent to me investing in something that guarantees me a 7% return.”

Investment risk is not so easy to decipher.  In my last article and in the worksheet attached above, I assumed domestic stocks will return 10% a year.  Well, in 2020, they fell over 30% at one point.  In 2019, they increased by 30%.  In 2018, they fell by 4%.  In 2017, they increased by 22%.  I can go on, but the point is that most investments produce varying returns year-over-year, and they can lose money too!  So, your average return of 10% only works for a very long holding period.  If you are under 50 and saving for retirement at age 65, for example, you most likely have a long holding period.  If you don’t have a long holding period and you’re actually investing for, say, next year’s living expenses versus paying down debt, you should pay down debt almost all cases!  This complicates things, so people who are not expecting to save for a longer period of time should seek some personalized advice on this topic.  For all others, just know that your “average” return is going to be the average of big up years, big down years, and relatively boring years (stocks went up by 1% in 2015 -yawn-).

Retirement Plan Matches

How do you double your money in one year?  Easy, contribute to an employer retirement plan that matches your contributions.  Contribution matches often tilt the scales in favor of investing versus paying down debt, and these plans are often tax-advantaged too.  For instance, consider you have credit card debt at 10%, and you can earn 10% after taxes investing with your employer’s 401k plan.  Therefore, you should be relatively indifferent between investing or paying off debt since they cost the same.  Now, let’s add a 100% match to your contribution.  That means that in the year of your contribution, you will not only earn an expected 10% on your investments, but you will also earn a whopping 100% because of your employer’s matching contribution.

It looks something like this:

Table outlining the annual expected return of a loan with a 10% interest rate and an investment with a 401k match.
It often makes more sense to get your 401k match versus paying down debt! Sorry for phone users that this picture might be blurry!

Or, for more visual people who prefer charts, see below:

Chart of how loan interest compounds on a $50,000 loan versus a $50,000 (hypothetical) 401k contribution with a match.

Summed up, if you employer offers a match on contributions within your retirement plan, it is generally more advantageous to invest and receive your match than to pay off existing debt.

Summing Up

It all comes down to opportunity cost.  Maximizing wealth means placing your dollars where they will grow (investing) or prevent wealth shrinkage (debt) the most effectively.  In these last two articles I presented some general pointers to help you determine what to do with your cash flow.  If your situation is potentially more complex and you could use some help, schedule a call and I’ll see if I can help.

Leave a Comment

Your email address will not be published. Required fields are marked *