It’s a question as old as the stock market itself. At what interest rate should someone invest instead of paying off debt. I get asked this all the time. Financial professionals wax away discussing why investing is better. Heck, I’ve even written a post about how debt can be good for you financially!
So things can seem a bit confusing for those starting out. Especially when you are trying to figure out your financial plan.
The short answer here is that there is no definitive answer. It all depends on you personally. But that doesn’t mean that there is no answer or it’s an excuse not to think about things.
So let’s dig in a bit deeper…
Why do we even care about this?
Let’s revisit how net worth works.
And first I’ll mention again that, while not perfect, net worth is the best measurement for wealth that we have.
Net worth is equal to your assets minus your liabilities. Your assets are things you own that put money into your pocket. This includes things like stocks, bonds, and cash-flowing real estate. Liabilities are things you own that take money out of your pocket. This includes things like non-cash flowing real estate (your primary home) and any sort of debt.
So, based on this definition, there are two ways to increase your net worth/wealth and advance on the path to financial freedom. You can:
- Increase your assets, i.e. invest, or
- Decrease your liabilities, i.e. pay off debts
In reality, you have to do both of these things. You can’t do just one or the other. Debts need to be paid off. And being debt-free but having no investments will cause you to lose purchasing power due to inflation.
So, we are back to our starting question. How do we determine how much to invest and how much to pay off debt?
Interest arbitrage explained…
Before sharing my thoughts and strategies about exact rates, I think it’s important to discuss the concept of interest arbitrage. Because that is really at the crux of this whole argument.
Interest arbitrage is the concept that if you have debt at a 3% interest rate and an investment that will yield 10% returns, there is a 7% arbitrage (10%-3%) between those two wealth-building activities. In this contrived example, investing your money instead of paying off debt would yield you a 7% advantage.
And mathematically, there is no argument. Interest arbitrage wins every time. And proponents will commonly bring it up as a reason for individuals to invest instead of paying off low-interest debt (more on this later).
But there are some serious flaws in this argument…
- First, paying off debt is a guaranteed return. You pay off your debt and you stop paying that interest. If the interest rate was 5%, that’s a 5% return on your money. No investment – not even something pretty stable like a bond – is guaranteed. Some are less risk and some are more risk, but none is risk-free.
- Prolonging your debt plays into the hands of the debtor. One of the worst pieces of financial advice that I ever received was that I should die with my student debt. By drawing it out and always making minimum payments, my mentor thought they were beating the banks at their own game. The problem is, the banks were laughing, well…to the bank. Debtors want you to take a long time to pay off your debt so you pay more interest. Don’t play into their hands…
- This argument ignores the behavioral aspect of personal finance. I often have people tell me they aren’t paying off debt because they are going to use that money to invest. And then they don’t. They either keep waiting on the sidelines or use that money to buy another liability. Paying off a 2% debt is a better financial move than no financial move at all.
- Also ignored here is the emotional aspect. Bad debt is a drain on our spirit. Trust me, I know. I still have much of my initial $500k+ debt that I am paying back. I’ve never met anyone who was debt-free and told me they wished they’d stayed in debt longer so they could invest more. And that’s telling.
Let’s finally answer this question, at what interest rate should we invest instead of paying off debt?
In my mind, here are the 3 factors that I believe are most important in making this determination:
- The interest rate on your debt
- Your expected returns on an investment
- Your risk tolerance
The first two make a lot of sense based on our previous discussion of interest arbitrage. But it’s the last factor that takes into consideration the 4 points that I listed about as flaws of the interest arbitrage argument.
In my mind, for me to invest in something rather than paying off debt, the return on that investment needs to overcome the:
- Interest rate of my debt
- Non-guaranteed nature of any investment
- Emotional and behavioral benefits of paying off debt
And on the flip side, for me to forgo paying off debt and instead invest in something, the following criteria need to be met:
- A higher expected investment return
- Reasonable investment risk
- A lower debt interest rate
So, what is my interest rate number below which I will invest instead of paying off debt?
For me, it’s 3.5%.
And, on the flip side, the expected investment return that would lead me to consider forgoing debt payments is 10%.
And you can see evidence of this in my written financial plan here.
That’s why I continue to pay off my re-refinanced private student loans despite a relatively low interest rate. It’s why Selenid and I invest in private real estate with a greater than 10% expected cash-on-cash return using our real estate investing criteria instead of using that money to pay off debt.
A quick self-critique
My guess is that most people will think the following about my chosen invest rate cut offs:
- That my debt limit is set too low, and
- That my investment return goal is set too high
And you know what…I don’t care.
Because, like I said at the start, this is a personal decision. And I know that our plan will allow us to reach financial freedom. If I adjusted these personal guidelines could I end up with a net wort that is 5% higher at the end? Maybe. Who knows? But it’s not a contest to see how high you can get. It’s just about reaching your goals so you can live on your own terms.
What I can tell you is that this skews towards the conservative side. Which I think is a good place to start for most. So these are the numbers that I throw out there when people ask.
- Beware of biased advice. Many less conscientious financial advisors will persistently recommend investing rather than paying off debts. Why? Well, because they make money based on you investing your money. When you use money to pay off debt, they don’t make a cent. This is not to say that any recommendation to invest is a bad one. But keep this bias in mind.
- If you are paying off debt or investing, you are winning. This may be the most important point. Look, if you are paying off debt or investing to the point that this question comes up, chances are that you are doing great. And any time you invest or pay off debt, you are increasing your net worth. So, while this is an important discussion, the most important thing is that you are taking action.
- I again want to reiterate that we all should be doing both of these things – paying off debt and investing. Not just one or the other. This whole discussion about at what interest rate should you invest helps set how much of your savings rate you dedicate to debt service and investing respectively. That’s why creating a personal financial plan is so important. And you can always use mine as a guide to create your own if you don’t already have one.
Here are some great additional resources for anyone looking to elevate and optimize their personal finances on the path to financial freedom!
- How Much Is Enough Retirement Savings?
- Physician Side Gigs to Make You Passive Money
- Debunking the Myth of the Doctor Car!
- The 3 Most Tempting Current Investments to Avoid
And don’t forget to check out my best-selling book, Money Matters in Medicine!
What do you think? At what interest rate would you invest? Or pay off debt? Have you set a cut off point for yourself? Why or why not? Let me know in the comments below!