We’re going to address the most common question I see. Should you pay off debt or use your money to invest? Over and over again it is asked, always with slightly different details. 95% of the time, the answer is a simple “It depends.” So today, we’re going to talk about what it depends on. I’ve written about this topic before, but it has been six years. I also included a chapter on this in The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing, but that was now four years ago. Over those years, we’ve actually paid off all of our debt, so are among the few who no longer have this dilemma. But until you become debt-free, you’re going to struggle with the dilemma just like everybody else does.

Avoid the extremes 

Perhaps the best advice I can give is to avoid extreme positions. 95% of the time there is no right answer, but 5% of the time there is. If you’re giving up an employer match in order to pay off debt, you’re making a mistake, basically leaving part of your salary on the table. If you’re carrying 30% credit card debt in hopes that your investments will outperform it, you’re making a mistake. But for just about everything else in between, I can come up with a situation where it might make sense to invest, but where it could also make sense to pay off debt, no matter what kind of debt that might be.

Paying off debt and investing are both good things

Here’s the other thing to keep in mind. Paying off debt is a good thing to do. It builds your net worth. Investing is also a good thing to do. In general, it also builds your net worth. They’re both good things to do. One of them isn’t wrong and the other right. At its worst, one is a little more right than the other. If you can’t tell which one is better for you, it probably doesn’t matter much. So don’t worry about it too much. If it is really paralyzing you from doing either of them, just split the difference and put half of your extra money toward debt and half toward your investments. Trust me, in the end, this decision isn’t the one that is going to determine whether you are financially successful or not. The important decision is probably what percentage of your income is going toward building wealth rather than consumption.

7 principles that determine whether you should pay off debt or invest

1. Attitude toward debt

Some people hate debt. I dislike it enough that it was a major factor behind why I spent four years on active duty. The more you dislike being in debt, the more likely you are to want to pay it off instead of invest. Some people love debt. There are even people who think you should stay in debt your entire life. There is a significant behavioral aspect to this. Even though the math would sometimes indicate you should carry a debt and invest, behavioral and cash-flow considerations often argue for just paying it off.

2. Risk tolerance

If you aren’t going to invest aggressively, then you might as well get the guaranteed return available from paying off debt.

3. Available investment accounts

This has had a major effect on our debt vs investing choices over the years. If we still had a sweet tax deal being offered to us for investing, we usually took it instead of paying off debt. Yes, we paid off our mortgage in less than 7 years, but we never put an extra dime toward it until we had maxed out our retirement accounts, HSAs, and as much as we wanted to give to our kids (529s, UTMAs) first.

4. Anticipated investment

This is where the math comes in. If you’re expecting to make 10% and your debt is at 2%, even if it is 2% variable, it seems kind of dumb, at least from a mathematical perspective, to pay off the debt. So in this respect, perhaps investments with high expected returns get purchased before paying off debt and vice versa. Bear in mind the only returns that count are the after-expense, after-tax, after-inflation returns. Market valuations might play into this as well. The higher the valuations, the lower expected returns may be. Eight years into a bull market? Maybe you should pay off your mortgage. Market just dropped 40%? Maybe it’s time to invest. Market timing? Sure. But if there is no right answer to the question anyway, why not?

5. Interest rate of the debt

On the other side of the mathematical equation is the interest rate of the debt. High-interest rate debt should, in general, be paid off before low-interest rate debt and investments. Bear in mind the only interest rate that counts is the after-expense, after-tax, after-inflation rate. So a tax-deductible debt (like many mortgages) is less of a priority than one with an equal interest rate that is not deductible. Likewise, if you have a low, fixed-interest rate debt and inflation is high, well, you’re going to be paying that debt off with less and less valuable dollars the longer you drag it out.

6. Level of wealth

Your level of wealth can affect whether or not you should pay off debt. You’ve heard the phrase before, “When you win the game, stop playing.” We carried our mortgage a couple of years longer than we had to in order to invest in a taxable account. Then we became wealthier faster than we expected. It started seeming kind of silly to still be carrying that little old debt around, so we paid it off. But if you have a 4 figure portfolio and are decades away from financial independence, paying off your 2.5% mortgage early probably shouldn’t be your priority.

7. Asset protection and estate planning

Just when you thought it couldn’t get more complicated, let’s bring asset protection and estate planning considerations into the equation. In some states, your homestead is 100% protected from creditors. If you live in one of those states, perhaps you prioritize paying off the mortgage a little faster. If you’re in a state where it isn’t protected, perhaps it is less of a priority. Likewise paying off debt prior to maxing out retirement accounts with their awesome asset protection and estate planning benefits. What about an ill 85-year-old with some debt but also some taxable assets with low basis? In that scenario, it would make sense NOT to liquidate the taxable assets in order to get the step-up in basis at death. It might even be wiser to borrow against them rather than sell them.

The list

OK, despite reading those seven principles, some of you still can’t decide whether you should pay off your debt or invest. You want an algorithm that will tell you exactly what to do. So I’m going to give you an algorithm and make a list, just like I did six years ago and just like I did in the book. Savvy readers over the years realized those lists were not identical. And in fact, they’re both different from this list. That reflects the fact that a perfect list can’t even be made.

But this much I can guarantee you: If you just follow this list you’re not going to do anything stupid. Reasonable people are going to disagree with the placement of some items on this list. They may even argue about it for weeks in the comments section. That’s fine. But no reasonable, knowledgeable person is going to move something from the bottom of the list to the top of the list. This algorithm is good enough to lead you to financial success.

1. Get any employer match

Not getting this money is leaving part of your salary on the table. It would be very unusual for you to have a better investment or debt pay-down option than this.

2. Pay off high-interest rate debt: 8% or more

Not only does this “investment” come with a high rate of return, but it is also guaranteed.

3. Max out available retirement accounts

• 3b- Tax-deferred accounts first in peak earnings years
• 3c- Tax-free first in non-peak earnings years
• 3d- Include non-retirement tax-protected accounts in accordance with your goals: HSAs, 529s, UTMAs etc

This is where most of the arguments are going to be made. The Dahle Family funds our Roth IRAs, HSA, and 529s up to the state tax credit limit on January 2nd of each year. But we still make sure we max out our tax-deferred accounts during the year (401(k)/PSP, individual 401(k)s, Defined Benefit/Cash Balance Plan). Any other 529 contributions, UTMA contributions, and taxable investing is put off until those accounts are maxed out. But if you’re in a situation where you can’t max out everything and have to choose, well, there are no right answers. HSAs are triple tax-free, but you can’t stretch them or use them very tax-efficiently except for health care. 529s are good, but the tax break pales in comparison to a 401(k). Super-savers might benefit more from a Roth than someone who started saving late. Lots of little subtleties there, but the general principle remains- retirement accounts are great places to invest and if you don’t max them out in any given year you can’t go back and do it later.

4. Invest in assets with high expected returns

Some more room for argument here. What is a high expected return? Are stocks going to have a high expected return in the near future? What about over your entire investing horizon? What about real estate? Hard to say. But if you’re expecting to make 15-20% on an investment, it can make sense to not pay off 5% debt and invest instead. Heck, if you’re expecting 20%, it might make sense not to max out the retirement accounts first (or figure out a way to put the investment inside the retirement account.)

5. Pay off moderate interest rate debt (4-7%)

I’m often amazed how many people are willing to carry around debt like this. I still find a 5-8% guaranteed return to be a very attractive use for my dollars. That investment better be very compelling if I’m not paying this sucker off ASAP.

6. Invest in assets with moderate expected returns

OK, that makes sense. If you expect to make 5 or 6% on something, it can make sense to carry a 2% loan.

7. Pay off low-interest rate debt (1-3%)

I’ve never been a huge fan of debt. But I’ve avoided paying it off a couple of times in the past when the interest rate was really, really low. I would certainly pay it off before dumping a ton of money into a bond fund paying 2% or a saving account paying 1%. Not much arbitrage there.

8. Invest in assets with low expected returns

I hope nobody is surprised to find this one at the bottom of the list. In fact, some people might even put “buy a wakeboat” ahead of this one.

I hope this post is helpful to you as you weigh your own pay off debt vs. invest decisions. Truly, it depends. Not only is the answer different for different people, but it can be different for you as you progress from one stage of life to the next.

James M. Dahle is the author of The White Coat Investor: A Doctor’s Guide To Personal Finance And Investing and blogs at the White Coat Investor. He is the creator of Fire Your Financial Advisor!, a high-quality 12 module course with a little over 7 hours of videos and screencasts, a pre-test, section quizzes with answer explanations, and a final exam. The goal is to take a high income professional from square one, teach them financial literacy and help them write their own financial plan.

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