When it comes to personal finance, the question of whether to pay off debt or invest may be one of the most highly controversial topics there is. So, I want to tread carefully. When answering this tricky question, it’s important to qualify the kinds of investments that make sense. I personally feel if you are making the choice between paying off debt and investing in a 401(k) or similarly qualified account, the answer should unequivocally be to pay off the debt first. It will actually increase your ability to save later.
Done! I could almost have turned this post into a tweet.
But there is actually much more to consider. Life and planning for the future are, of course, more nuanced than the choice between paying off debt and funding a 401(k). Let’s look at some scenarios to see when and where investment might make sense compared with paying off debt.
Starting a Business
Starting a business is definitely an investment. The rewards that have come with starting our business have been awesome and humbling. The lives we have touched and that we have been touched by – that experience alone has been priceless. Both Phillip and I still have debt and are not 100% debt-free. Does that mean we should have not started our business until all of our debt was paid down?
I can’t imagine still working the way I did – for someone else. For me, I would be squelching a burning desire to help others understand the power within themselves and the uncommonness that pervades all of our lives. Would I trade that off just to be completely debt-free? That was not the right path for me. I do not want to minimize the risk, though. Taking a chance on a new business venture is scary. The risk is real and can create more debt than when you started if things go wrong. We are going to talk more about business-related debt in a future post, so stay tuned for that.
Real Estate Investment
Now, let’s compare paying down debt vs. buying a rental property. As with anything, there is a right way and a wrong way to purchase rental properties. So this is not about buying properties in Vegas at the top of a market cycle with a cash advance from a credit card, but doing it the right way.
Rentals allow you to structure your debt at longer terms to buy an asset that produces additional cash-flow. It also activates and leverages other people’s time and money which can help you pay back debt faster. Further, because of the possible tax considerations that can allow you to itemize deductions potentially above a standard deduction, this kind of property investment can bring tax advantages as well.
One rental property can pave a path to multiple properties. Scaling up like this can help you pay down, consolidate, or eliminate other debts completely.
Here’s where we tell you to slow down on choosing investment over debt reduction. Typically, the power of real estate is the leveraged potential return on the entire value of a property. Whereas, using leverage with stock investing is very dangerous and not something we would recommend. Plus, the income derived from trying to build up a stock portfolio is not typically greater than just paying off the debt and freeing up that cash-flow.
Let’s dig a little deeper: If you have $10,000 in credit card debt that is costing you $300-$400 a month or about $3,600 to $4,800 a year in cash-flow, your stocks would need to generate a 30-40% return to justify not using that money to pay off debt. We would go so far as to advise cashing out the stocks and paying off the debt. Then we would want to see you develop the discipline to live without building up a credit card balance again. Once you have that discipline down, you can look at investing in stocks.
Another scenario: Say you have $100,000 invested in the stock market, but you still owe $100,000 on your house. The income from that portfolio may be $5,000 a year sustainably, which probably would barely cover the mortgage payment on your $100,000 mortgage. Compare that again to a rental property where you put $20,000 down on a $100,000 house and you are netting $3,600 – $4,800 a year in cash-flow. Now your tenants are helping you pay off your credit card!
This topic is hard and has a lot of moving parts. There is no one size fits all approach. Each one of our clients is unique and before we give them advice on this very topic we ask questions. We know where all their numbers are and we talk for hours about a unified plan and path forward that everyone agrees to.
Just a few of the questions we help people consider:
- Have you built a business before?
- What do you understand about investing?
- How would it feel to have this debt behind you?
- Do you have a massive opportunity in front of you that you have been working on that needs one last push?
- Do you have a competitive advantage in something that warrants more of an investment?
- Do you or your spouse lose sleep at night over the debt?
- Is someone in your family helping you pay something off?
With so many variables to consider, the choice between paying down debt and investment can be challenging. Hopefully, this is a helpful tool in understanding your options and the questions to ask as you decide on the best use of your hard-earned dollars.