Do I pay down my debt more aggressively or invest? That is one of the most common questions that I encounter when speaking with early career physicians. There are good arguments on both sides of the debate. The answer involves a mixture math, probability, and personal psychology. So, it is different for everyone. Learn more about each of those factors to find the right answer for you.
Why is debt repayment a tough choice?
It is simple to say, “trash your debt”. Aggressive debt elimination is good logical advice, but people still struggle with following it. Most professionals face competing priorities when they finally start practice and earn a higher income. Debt repayment, investing, and pent-up demand all compete for those dollars. The number of dollars available may also be less than anticipated when time shrinks and our tax rates grow. Spending on one priority means not spending on another, and they all require some attention.
Eat the marshmallow. So, that you don’t eat the whole bag.
After years of training, we (and our families) have pent-up demand from delayed gratification. Actually, we are masters of delayed gratification. There is a moldy marshmallow sitting on our parent’s kitchen table.
If we don’t celebrate with a White-Coat Rumspringa and blow off some steam, there could be a pent-up demand explosion. Or even worse, one with a hangover from the ongoing costs, like I had. So, some current lifestyle spending competes for your dollars against debt repayment and investing.
After you have fed the delayed-gratification-beast a marshmallow (not the whole bowl), you face the dilemma of how to spend the remaining money. Is it making Future-You not have to work so hard by paying back debt now? Or is it helping Future-You by investing to increase their passive income and allow them to work less? Your future self will thank you either way, but the two possible paths to the same goal cause angst about which path is better.
Debt and investments both compound over time.
Most early career physicians have a large student debt hanging over their heads. Others may have taken on a mortgage to buy a house or a line of credit to renovate it. Those debts are spent future income, and the future has arrived. It is time to earn the money and pay the debt. The debt will continue its compounded growth if you do not.
Unfortunately, the years spent working towards a high-income career or business is also valuable time lost for building investment accounts. You must start investing for your future to take advantage of compounding returns. A small delay in investing now is, functionally, a compounded loss later.
So, people generally gravitate towards whichever has the highest rate of return. For high interest debt, like a credit card, that is a no-brainer. Pay it off urgently. For lower interest debt, like a mortgage or professional line of credit, the interest rate and expected investment returns may be closer. However, there still is much more to consider than that.
Investing while in debt is leveraged investing.
Using debt to invest is called leveraged investing. Investing while still in debt or taking on new debt to invest are logically equivalent. You have decided to invest rather than pay down debt. Like a lever, debt-fueled investing uses borrowed money to magnify gains. In this case, you borrowed the money already, but are avoiding repaying that to get a faster start with investing.
That head-start magnifies your potential investment gains in the long run. However, leverage can also work in the opposite direction. If your investment does not work out as you hoped, then leverage magnifies the impact of the loss. So, you must carefully weigh both sides of the risk-return equation before you raise the stakes using leverage. With leveraged investing, the outcome depends on both the investment and your ability to stick to the plan. To stick to the plan, you must be emotionally and financially prepared.
You must be secure now before attending to your future.
Reduce debt to a safer level before even considering investments.
Before you can even consider investing, you must make sure that your debt is down to a level where you can sleep at night and absorb cashflow crunches. Unexpected expenses occur frequently in real-life and should be anticipated. Investing must be long-term, or it is gambling.
Investment markets move in both directions on a daily or even yearly basis. Due to those short-term fluctuations in value, a horizon under 3-5 years may be too short for a serious investing plan. All leveraged investing is serious business. You don’t want to be forced to sell good investments at a bad time to pay for something.
Debt magnifies volatility & behavioral risk.
You may not be forced to sell an investment at a bad time for cashflow, but you could still be forced into that mistake by your emotions. Evolutionarily, emotions have helped us by forcing us into the actions needed to survive. That may harm us as investors if market moves induce the same fear as a T-Rex.
That could take the form of FOMO when markets rise. Why pay off my debt? I am an investing genius and can do it anytime, but not if I miss the market! Fear can really escalate when markets drop. When that happens, the herd often stampedes for the exits, and it is easy to be swept along.
A long-term investing plan requires you to stick to the plan through the ups and downs of the market (volatility). Leverage magnifies volatility and increases the risk of your behavioral beast taking control to sell at a bad time. Watching your $100K investment drop to $70K is scary. It is much scarier when you still owe $100K in debt. Emotions are powerful, and fear is an incredibly powerful force to drive a sale at the worst possible time.
Paying Debt Has the Best Risk-Adjusted Return.
Potential risk and reward are very closely linked with all investments. The collective intelligence of the market sees to that. If you don’t see potential risks commensurate to the hoped-for returns with an investment, then you are missing something important. The closest thing to a “risk-free” investment is generally a short-term US treasury or a short-term liquid GIC. The only truly risk-free guaranteed return is paying off debt.
Debt reduction is usually the best after-tax-risk-adjusted investment around.
Paying down debt is risk-free. It is a guaranteed return equal to the interest paid. In contrast, all other investments have their expected return very closely linked to the risks being taken. That applies whether it is the interest rate of a bond, GIC, business venture, or equity investment.
Debt repayment is also tax-free. If investing in a personal or corporate investment account, a business venture, or real estate – the income is subject to tax. Even a registered retirement savings plan (RRSP) has tax-owing on the investment income – it is just paid later when you take the money out. Fortunately, an RRSP comes with an upfront tax refund making it tax-free in the present and attractive if your current tax rate is high.
If your tax rate is 33%, that effectively bumps the comparable return of debt repayment by 50% compared investment income: 4%/yr interest savings is like 6%/yr investment income.
It is even more dramatic if you are being taxed as a corporation or the top personal rate. At the 54% marginal rate, you would need investment income of 8.7% to break even.
Unless you are investing in tax-free account, eliminating debt is the best risk-adjusted investment in existence by a wide margin. People often forget that the probability of outcomes in addition to the magnitude is part of logical decision-making, even in the distant future.
Loan interest is a sure thing and market returns are not. However, most people must take some risk to meet their financial goals. Long-term passive index investing through a tax-free savings account (TFSA) or an RRSP (while in a high tax bracket) probably have the next-best after-tax-risk adjusted return. There are also a couple of special situations that may nudge the scales.
Debt forgiveness and/or employee matches are also risk-free.
Some governmental student or business loans may come with some forgiveness. Either through government largess, tax credits, or a return-of-service contract. Aggressively paying down other loans (like your line of credit or a credit card) has no tax downside. In contrast, losing some forgiveness by paying these other loans early instead of letting someone else do it has the opposite effect. The lost benefit is functionally equivalent to a tax. That may tip the scales towards investing, if that is the only debt you have left.
Some employers or professional associations (like Doctors of BC) may have employer matching of contributions to a TFSA or RRSP. That is part of the negotiated compensation package, and you probably do not want to miss out on that risk-free return. Similarly, a Registered Education Savings Plan (RESP) has government grants that goose your returns risk-free.
Corporations lose some tax-deferral to access money for personal debt.
Those using a corporation face another dilemma. One of the biggest benefits of a corporation is to smooth personal cashflow. You could more pay more excess income out of a corporation to more aggressively pay down personal debt. However, that also raises personal tax rates. You may save on interest (a sure thing) but also pay more in personal taxes to access the money (also a sure thing).
The balance between those two predictable expenses is complicated. However, it may be worthwhile to smoothly take more out of the corporation over the course of several years to pay debt without bumping up into too high of a personal tax bracket. The retained corporate earnings would be invested through the corporation, even while in debt, to take advantage of the tax deferral. A closer look at this balance and some other strategies to efficiently move money out of the corporation to pay personal debt will be a future post.
Five big reasons to pay down debt before investing.
(Except maybe passive index investing in a tax-advantaged account)
#1: “I wish I had more debt. It makes me feel so good”, said No One. Ever. Okay, well, except maybe this guy. For the rest of us, paying debt feels good and it gives you options.
#2: Gain knowledge and experience before aggressively investing with leverage. It will take you some time to pay down debt and you can use that time to learn the basics to invest wisely. Once the debt is at a safe level, you can gain some experience investing using your TFSA. A self-directed RESP is also attractive due to government grants and an RRSP for the tax refund if you are in a high tax bracket. Leverage raises the stakes, and it is best to learn any hard lessons without it.
#3: Paying existing debt first, then deliberately taking a new loan to invest has tax advantages. The interest on your student line of credit is not tax-deductible even though it helped you to become a high-earner. Nor is the interest on your consumer debt or mortgage. However, if you take a loan or mortgage explicitly to invest in a tax-exposed account then the interest may become deductible against your income. Of note, loans to invest in a TFSA, RRSP, or RESP do not allow interest deduction. Another reason to fill those accounts first if you decide to invest while still in debt.
#4: Financial security improves your odds of not messing up with leverage. If you do decide to use leverage to invest, you will get better interest rates if you have a proven strong financial position first. Further, if you are in a less vulnerable position, then volatility is less scary. Avoiding fear is vital for sticking to any investing plan and is of magnified importance when leverage is involved.
#5: Create space to use your line of credit to your advantage. Paying off your line of credit gives you the space to consider using it as an emergency fund or to the smooth cashflow crunches that come with quarterly tax installments. That usually beats sitting on a pile of cash that earns highly taxed paltry interest rates. In contrast, disciplined use of a line of credit could mean more money invested for higher returns instead.
The Right Choice For You
In summary, the right answer to the question of whether to pay debt vs invest is personal. However, there are a number of logical, emotional, and pragmatic factors that should inform that decision. It may also not be all or nothing. Learning to DIY invest by using your tax-sheltered accounts, may be a reasonable compromise for multiple reasons. As long as you are financially secure, emotionally prepared, and you use them to develop good investing habits. Otherwise, debt elimination usually wins. Regardless, choose a plan that you can stick to, lets you sleep at night, and builds your future security. That is priceless.
Another informative post LD! Thanks!!
I am curious about your excellent ability to have a 360-degree view of this and other such complex subject matters. Usually, for most, that wisdom comes after the fact, with 20-20 hindsight (and for some, it never comes).
– What percentage of your analysis/ideas/wisdom comes from experience vs foresight?
– How do you come to the conclusion that your analysis is exhaustive or you do feel there could be more that you don’t know? After reading this post, I am like, I could have never thought of possible debt forgiveness as a strategy to carry certain debts. BTW, usually, when faced with such a dilemma, my mind goes into overdrive and starts thinking, what else I haven’t thought of? Of course, when I get into analysis paralysis, I apply perfection is the enemy of good and move forward.
– I look at debt as plague (risk averse) so would rather pay a 3 % mortgage than invest in an ETF with 5 % return and looks like in general that seems to be what you are suggesting that debt elimination is usually better than investing (for N number of reasons financial and non-financial, including the psychology of debt/investing). My question is, what percentage of the population is able to act against this natural behavior?
Thanks PD.
Honestly, I would say that about 50% comes from experience. Half of that from mistakes I have made and the other half from trying to approach things from scratch. The other 50% I pick up from talking and listening to other people interested in or facing the same things. I get that from a combination of Facebook, teaching at conferences, and the comments on this blog. I know that there are always things that I haven’t thought of. The beauty of a blog is that I can update when I discover a mistake or write a whole new post when I encounter something that I completely never thought of. Has already happened twice this week – I don’t think I will run out of material!
I have watched the psychology of debt swing back and forth. My parents and grandparents were very debt adverse. They faced >10% interest rates coupled to inflation. I now encounter a lot of colleagues blasé about debt. We take on a lot for our training and acclimatize to it when payments are deferred and rates low. Same with mortgages amortized over 30 years. I sit somewhere in the middle. I aggressively paid my loans and mortgage when I graduated – rates were high and I didn’t have the financial cushion. We took out a mortgage at <2% a couple years ago and deliberately invested it via my wife.
In one of my upcoming posts, I describe debt as a power tool. We can build things faster and better - or we can cut our fingers off with a moment of inattention. So, my approach is to use it carefully. Without debt, I wouldn't be a doctor and wouldn't have bought a house until my kids were teenagers. I really do think the "right" answer is different for everyone and may change for that person over time too.
-LD
Could you please share a graph for the comparison of “ rate of return required for same cash in hand “ that you showed for a 33% tax bracket?
But in > 50% tax bracket
(I’m in NB, Canada)
Sure. I was going to do that in the article, but I didn’t want to scare people. Will add it shortly. In the 54% tax bracket, it basically means you must earn more than double the return.
-LD
Love it, LD. In particular the part about at least getting debt to a manageable level before even thinking about investing a significant amount. There are a lot of young doctors with debt who loaded up on cryptocurrencies, hoping it would be a panacea.
You touched on this too, but in my experience, the right answer for a lot of people who are interested in being self-directed investors is to prioritize debt, but start investing a little at a time too. Building confidence with small amounts of money is such a valuable experience. Then, when the debt is paid off, you have both the experience and the infrastructure of accounts to shift those debt payments over to the investment accounts.
Thanks again. Love that you have found renewed enthusiasm for building your content here!
Thanks Matt. I think that starting to invest on a small scale after debt is controlled is the way to go too. I actually think the TFSA is the perfect account. After-tax, so good when still at a low income. Tax-free so easy to beat interest rates if you use a long-term diversified investment strategy, like an index ETF. The main limiter is size – also great for someone just starting out. It can then build good habits before dealing with more money and teaches you that you can actually do it yourself. A major long-term advantage. I actually had that in the first draft of this post, but I chopped it out to make a stand-alone post (coming soon).
-LD
Love the uncluttered logic of this post. I feel that I have been fed a lot of baloney over the years which has created a twisted logic of contributing to investments despite outstanding debts. I now realize that there are more bull**** markets than bull markets. Through the retrospectoscope there are several moments when I should have just paid down debt (notably before the 2009 crash) rather than invest. I’m looking at a 30k debt on my line of credit and 30k in my bank account right now. No logic to it but I hesitate to pay off this canker which will bring an immediate 5% savings. The LOC will still serve as an emergency fund if I pay it off. After reading your article, I might manage to do it. Maybe anesthesia would help.