Should I Invest While Still In Debt?

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Should you invest while still in debt?

Yes and no, but for most people – no.

Investing while still in debt is usually not a wise strategy because it is likely that you are paying more in interest on debt than you would earn in interest on investments.  That is not always the case, but it is the most common case.

So is investing while you are in debt ever a good idea?

Investing is NOT a good idea if…

1.  You still have high interest debt

I still have over $10,000 in high interest debt at 9.32%.  While I still have this debt, unless I can earn a guaranteed interest rate of 10% or higher on my investments… I’m actually losing money.

Rather than invest while I still have this looming high interest debt, it is in my best interest to pay off this debt… then begin investing.

2.  You do not already have well established personal cash savings

Currently I have just over $3,000 in my interest bearing savings account.  Before I begin channeling money into investment accounts, I need to grow this significantly larger.  How large?  That depends on your situation.  Personal finance is personal so save whatever amount works for you and your situation.  Before investing, I intend to build my Emergency Fund to $20,000 (which is equal to 6 – 9 months of current family expenses.)

Investing IS a good idea if…

1.  Your only debt is low interest

If the only debt you have left carry low interest rates, then investing is a good idea.

What debt is low interest debt?  Any debt that carries a interest rate that is considered low.  I suppose this can be all relative, but typically mortgages and student loans fall into this category – as well as some business and personal loans.  For my wife and I, our low interest debt includes our 1st mortgage (5.625%) and our student loans (mine at 6% and hers at 4%.)  Once these debts are the only we have remaining, and our Emergency Fund is funded with our 6 – 9 month buffer, most of our extra money will then go toward investments.

2.  If your employer matches your 401k contributions

If you have the benefit of an employer matched 401k, then it is almost always a good idea to contribute, even if you are still in debt.  Reason being, it is free money.  Typically employer matching programs pay 50 – 100% of what you contribute up to a certain percentage of your salary.  For example:  Joe earns a $3,000 monthly salary, his employer matches 100% of his 401k contributions up to 5% of that salary.  So if Joe contributes $150 every month, his employer will also contribute $150 every month.  That’s smart Joe.

You can see that not contributing will effectively cost Joe $150 of free money each month.  That’s not smart Joe.

There are a few exceptions to this rule.

  1. Your employer contributions are vested over several years and you do not plan to be with your employer long enough to realize the benefit. For example:  you become vested 20% each year starting with year 2.  So the 1st year you are 0% vested, 2nd year=20%, 3rd year=40%, 4th year=60%, 5th year=80%, and you will not be 100% vested until your 6th year with the company.  Clearly this is a problem if you only plan on being with the company for 1 year.  This is the plan that my employer currently uses.  I have been employed with them for just over 2 years, so I am now 20% vested.
  2. Once your bills and all the other expenses in your budget are met, you simply have no money left to invest. If this is the case, then you are living beyond your means and simply need to reduce your living expenses and make room for your investments.  If the only debt you have left is low interest mortgage/student loan debt, there is no reason your expenses should equal your income.

Remember compound interest

The law of compound interest simply states that sooner you begin investing, the more you stand to earn.  Does that law negate the previous points in this article regarding when not to invest?  Absolutely not.  Why?  Because this law can work for you or against you.  If you carry high interest debt, then the law is working against you and you need to pay that debt off as soon as possible.  If you have no high interest debt then you should begin investing as soon as possible thus harnessing the positive power of compound interest for yourself.

Where do you stand? Should YOU invest?



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1 nickel

Unless the situation is totally dire, I would definitely invest enough to get any available retirement match. Beyond that, I would rank paying down high interest, non-deductible debt ahead of investing. Once that’s gone, I’d be back on the investing bandwagon — there’s certainly no harm in carrying a mortgage while building up your nest egg.

2 Kyle

I agree with Nickel, get the company match and then get your stuff in order. I would also throw in that your second mortgage does not count as a mortgage so take care of that too, the deductions aren’t worth the hassle of carrying two mortgages.

3 Matt Jabs

Yeah, I see the relevancy… but I think I’m going to stick to paying off the $11K left in high interest debt then start investing. Once that’s gone I’ll contribute to get the match then attack my 2nd mortgage (that like you said, isn’t really a mortgage at all.)

4 Bible Money Matters

Personally I’d pay down the debt as fast as I could – investing to match if there is one ( i don’t have one). Once you’ve paid off your debt by getting extra jobs, using found income/etc – there’s plenty of time to go crazy with investing. Just get that pesky debt off your back first!

5 Matt Jabs

My online endeavors are going to make me around $1,000 this month and will hopefully keep growing so the LORD may be providing for that 12/31/2009 deadline after all. I never doubted for a second! :-)

6 Lakita

Matt,

I think this is a great guideline for a very popular question and I agree with the principal of getting rid of the high interest debt first with the exception of 401K matching where applicable.

It seems like your using 10% as a determination of high vs. low debt, did I read that right? If so, I’m curious how you came up with that number? Is it a personal decision or is that a statistic? I’ve personally been using 8% as a determining factor, but that was for me personally.

Kita

7 Matt Jabs

Good question Lakita – actually I consider anything over 6% to be high. My student loans are at 6%, wife’s are 4%, 2nd mortgage at 8.8%, 1st mortgage at 5.625% and Lending Club loan at 9.32%. Another consideration is whether or not the interest is deductible for tax purposes (mortgages & student loans.)

As you can see I will pay off the LC loan, then the 2nd mortgage, then tackle the student loans and 1st mortgage.

8 Robert Espe

I have two debt categories: first mortgage, and anything else (consumer). I’m of the opinion that all non-first mortgage debt (including student loans) should be paid off before you invest, although I agree you should obtain any available matching funds, after all it is a 100% return.

The reason is that since investing is risk based and requires a long time table, to do it right, you can’t pull money from your investments. But owing people money, even if the interest is low requires monthly payments, and if your income is reduced, and you can’t make those payments, you will be forced to liquidate your investments, and they come to nothing. Even worse, if you lost money on those investments, and they won’t recover without waiting 5 years you don’t have, then you are in a really big hole.

Even the first mortgage is worth thinking about. If you do the math, even if you invest all surplus income, take maximum tax advantage, and reinvest that money, after thirty years, you will come out just barely ahead of someone who paid their mortgage off, and then put all their surplus into investing. HOWEVER, that is dependent on 30 years of consistency from the tax code (unlikely) and presumes upon your ability to make your house payment for 30 years (not necessarily in your control as these last few years have shown).

Most people are impatient, after all, investing is fun, and it seems like it will take so long to pay off a house. But most people could make enough money to pay taxes and buy food if they had no other obligations almost no matter how bad things got. That is security. Most people couldn’t quickly get a job with a similar salary if it was lost during a bad economy, and since investments wouldn’t be accessible to pay off a house, they could lose it (along with any equity). And it is no fun being homeless with a fat ROTH IRA, so it is worth thinking about. If you could save $20k a year, how fast could you pay off a home? It involves sacrifice, but it could be done.

If the borrower really is slave to the lender (as Proverbs tells us), you should first purchase your freedom (As Paul instructed all slaves to be better able to serve Christ), and worry about building wealth after.

9 Matt Jabs

Thank you for this EXCELLENT and biblical insight Robert. I actually plan on selling my house ASAP, but before I do that I have to pay down my 2nd mortgage because right now I’m upside down. If I could not sell my house, continuing to eliminate all debt before investing just may be the best decision I could make – based on scripture and the content of your comment.

Another thing to consider is the value of the dollar. If it declines considerably my investments will be worthless whereas freedom from ALL debt would be VERY valuable!

Like Dave Ramsey says, “You can’t go wrong getting out of debt!”

10 Mom

I agree with Robert, that the primary mortgage should not be overlooked. I have been in my home only four years. I have a 30 year fixed. I just did the calculations, courtesy of my lending institutions on-line mortgage calculators. If I start paying just $100 extra per month in December of this year, I can pay my mortgage off 7 years earlier and save almost $31,000 in interest. If I took the same $100 and invested it over a period of 19 years (the duration of my mortgage minus the original four years that I have already been in my house minus the 7 year early payoff figure)at a simple interest return of 10%, I would realize about $25,000. Theoretically, I would stand to gain another $6,000 if I were to pay off my mortgage early. At this moment however, my 401k is only realizing about a 4% return. It is invested quite conservatively because of the stock market crash of last year. Based on those figures, paying off my mortgage early looks even more attractive. The other thing for me, personally, to consider is my age factor. I am 56 years old, and getting out from under my mortgage early would ease my mind considerably in regard to financial issues in retirement.

11 Matt Jabs

Getting completely out of debt is my ultimate goal. It doesn’t make sense to some people, but I would rather be debt free than have debt with a bunch of investments.

Here’s one reason: If the value of the dollar collapses and I have no debt and no investments, it doesn’t affect me. If it collapses and I have debt and investments… my investments are worthless but my debt still stands, and I have lost my earning power.

I know not everyone agrees w/this concept, but to me… nothing is more financially valuable than complete freedom from debt! :-)

12 Hypatia

Matt said:
“If the value of the dollar collapses and I have no debt and no investments, it doesn’t affect me. If it collapses and I have debt and investments… my investments are worthless but my debt still stands, and I have lost my earning power.”

If your debt has a fixed interest rate, don’t you benefit by paying with really cheap dollars?

13 Matt Jabs

Not necessarily because it is likely that in this event my earning power will also take a dive.

14 Studenomist

@Matt I think that it could partially be a psychological issue in the sense that you do not want any debt in your life. I personal choose to invest but if I had any debt I would find it difficult to do so because I would always be thinking about paying off my debt.

15 Matt Jabs

Exactly…

16 Craig

I am not in this situation so I can’t speak from experience. If you have a retirement fund and matching through work definitely take advantage of it. but after that you should worry about paying down the debt first.

17 BG

My opinion is that 30-year mortgages are way, way to long — much can happen in 30-years: financial devastation by layoff, divorce, death, medical expenses, and the list goes on and on.

If you assume a 5% chance of something financially-bad happening in any given year, then in a 30-year period there is a 79% chance of something bad happening (at least once) in that 30-year window. This means, if you are planning on having a mortgage for 30-years, you absolutely MUST have a sizeable emergency fund to handle these situations: 6-9 (minimum), 12-18 months (ideally) of liquid savings — or you could lose your house.

You need to have this large CASH-based emergency fund because a financially-devastating event is more likely to happen when your stock investments are in the toilet (layoff when stocks are down as an example), and if you need to sell these investments AT A LOSS to cover your devastating event, then you would have been much better off paying off the mortgage early. Imagine selling stocks at a 40% loss due to a layoff a few months ago.

I would opt for a 15-year mortgage (or a 30-year payed on a 15-year schedule). Odds of a financially devastating event happening once in a 15-year time frame is 53% — so you are near 50/50 with a 15-year mortgage. Even better is paying it off in 10 years or 5 years: 40% odds and 23% respectively. Compare that with the 40-year mortgages people were getting a few years back: 87% chance (practically guaranteed) of a financial devastating event happening once in the 40-year window: and these people were getting these mortgages because that was the only payment plan they could afford, Insanity!!

Everyone must understand: investing in stocks, instead of paying your mortgage early, is an attempt at higher gains through a massive increase in risk. You are technically taking a loan out against your house to invest in the stock market.

If the market truly is efficient, and you are balancing risk correctly with a sufficiently large CASH-based emergency fund: then there technically is no gain from the investments… Any perceived gain is likely from (perhaps unknowingly) a large increase in risk.

Is that extra 3.25% gain really worth the risk you are assuming? Is your emergency fund large enough to cover that risk? Now look at the return on your investments and your emergency fund together (as a single portfolio): there should be no gain above the current mortgage rate if your are adjusting for risk correctly.

If investing in the stock market was such a “sure thing”, then why are bank lending mortgages anyway? Why aren’t they dumping everything into the stock market? Because it is more profitable for them to collect interest on your mortgage payments — and it is more profitable for you to pay your mortgage early.

18 Matt Jabs

Although I’m not sure where the 5%/year number comes from, I cannot argue w/anything else you have said.

At this point in my life, I see far more security and value in paying off all debt before investing. I plan to save $20,000 once my high interest debt is paid off, then I will begin tackling my mortgage and student loan debt until it too is gone. The only investment I will likely make will be to my 401k, to take advantage of the match, and maybe my IRA. Everything else will go toward debt repayment.

19 BG

Matt: the 5% number is a ballpark figure, but I think it is close — it could be computed based on unemployment figures, divorce rates, mortality/census data, bankruptcy filing rates, etc, etc. Right now, we have much more that 10% of the population in this category, but I think 5% (an average) is about right.

Saving in a 401k (with company match) is a must: don’t throw away free money — but you are not required to invest your 401k into stock investments. I’d argue to keep some of the 401k in relatively safe investments until the mortgage is paid off.

As for the Roth IRA, investments there grow tax free, so should be utilized before looking at any taxable-accounts.

It is fine to invest while you have a mortgage, but only for people with very-large emergency funds in something liquid that is earning a risk-free rate (CD ladder for example). The key here is that you need to have enough liquid savings to get you through likely financial emergencies without having to sell other investments at a loss — that is the only way to make the scheme work.

The point I am making is that paying off a mortgage early is also an “investment”, and an investment that has a guaranteed rate of return, practically risk free (keep the emergency fund), and has tax free gains. Weigh the “paying off mortgage” investment using the same criteria when looking at alternative investments.

How you invest money is your decision, and as long as you make a decision after looking at all the information, nobody can fault you for it.

20 Matt Jabs

Well said.

21 Colleen

But you are assuming probabilities that are not independent, which is not really knowable. Effectively your 79% number (which cannot be calculated without knowing whether the probabilities are independent are not.) You are effectively assuming that the probabilities are dependent — that’s dangerous, and known as the gambler’s fallacy — if he/she just keeps gambling, he/she has to win eventually. But that’s not true.

22 Colleen

I’m not trying to say that I disagree with your fundamental point, but I do think that the method you use to get there is fuzzy math at best.

23 Alex Fernandes

According to me if it’s profitable investment and from that profit you can payoff you debt, then go for it.

24 JoeTaxpayer

I agree with FCN, capturing the matching (401k), which is usually capped pretty low anyway, as in the $150/mo example, and then tackling the high rate debt next.
Look at the debt as similar to a fixed return investment. Right now, there’s uncertainty in the market, and a fixed 8% or even 6% is pretty desirable. The only debt I’d not pay so fast is a low interest mortgage that can be deducted. My mortgage is 3-3/4% after taxes, I think in the next 10 years the market return will beat this. On the other hand, Jane 2.0 starts college in 8 years, so I’m still adding just enough to the mortgage to match the date, pulling it in by a year or so.
Joe

25 BG

Joe) Excellent advice, I am also trying to pay my mortgage off before the oldest starts college.

26 Matt Jabs

My next debt to tackle after my Lending Club loan is paid off is the 2nd mortgage. It sits at a pretty high rate and I am looking to pay it off within the next 2 years – 3 tops. Then I will go after my student loan, etc, etc, etc.

27 Adam

I find the simplest demonstration of this concept is doing up your net worth statement once a month. If you don’t have a positive net increase monthly, then you allocated your funds incorrectly. Funds either add to the assets side or they decrease the liability side – or both. The trick is to find the right mixture to maximize your growth.

Adam

28 JoeTaxpayer

Adam,
How exactly would this work? With the cash side yielding nearly zero, to have the stock portion low enough so any decline in a month is compensated by new deposits? That would give me a stock allocation close to zero. What monthly downside do you have to allow for, 10%, 20%? Right now, 10% is about equal to 8 month’s pay for us, so the method you propose simply cannot work mathematically while having any realistic mix of stock in one’s portfolio later in life. First few years, no issue, but that’s when you can afford to be aggressive.

29 Adam

Hi Joe,

I guess that’s my point, in a round-a-bout way. Let’s say you have $1000 dollars disposable income after all household expenses and loan payments are taken care of. Now you have a choice, either invest it into an investment vehicle of some sort Bond\GIC\Equities\High interest savings etc., this would add to to the asset side of your networth equation. OR you could put it against a debt, Mortgage\LOC\CC\Loan and decrease your liability side of the equation. The question is, which choice will yeild you a better return. If you have a Loan at 10% interest, you will get a 10% return on your $1000 by simply paying that loan down by $1000. If you can only get a 3% return on a GIC\Savings acct etc, it doesn’t make sense to invest it into the asset side of the equation. The solution is simple, you get a 10% return by paying down a loan on the liability side.

Equities get a little stickier as there is an element of speculation involved in regards to return. Your current loans are absolutes though.

Clear as mud? lol.

30 JoeTaxpayer

Adam I agree with what you just wrote. Prior, I was caught up on “If you don’t have a positive net increase monthly, then you allocated your funds incorrectly.”

If one has no debt, and is investing, the goal of never having a monthly loss is tough if you are in stocks to any degree. The sentence I quoted threw me off. Maybe I misunderstood it. I agree that the focus of paying off 10% debt before investing is a no-brainer, one should do it. The next step, choosing between mortgage acceleration or investing is not so clear cut.

31 Matt Jabs

@Joe & Adam: good info guys. Per Joe’s last statement regarding mortgage payoff – I would accelerate. Why? Because it is never a bad thing to have no debt. If you choose instead to invest more rather than accel mort payments then you are assuming employment into the future… which is a gamble.

Paying off the house is paying off the house – anyway you slice it.

32 Mike

I have several thousand set aside for EF. After a recent revelation, I’m in the process of selling my investments in order to pay off home equity line of credit by summer 2010, then pay off mortgage asap while building the EF further.

33 Matt Jabs

Good stuff Mike – I cannot hardly believe you will ever regret that decision. Getting rid of debt is never a bad idea.

34 CreditLendingBlog

This is a very helpful post particularly for individuals whose employers match their 401(k) contributions. Helps them get free money.

35 Dan

a minister of mine years ago offered the suggestion of not buying on credit anything that goes down in value; in his estimation (and I agree) that meant college loans and mortgages…even second mortgagates, if it meant building on the house. But, consumer loans and credit cards, he advised against.

I like the “principle” behind it that the loan is only for long-term, to-your-benefit expenses. But, I agree that investments should follow behind debt-reduction. Good information; hope this gets spread far and wide.

36 TheGooch

Many people keep their mini-emergency fund in an Roth IRA , and then tackle debt, and then save for the job-loss(3-6month) emergency fund, and afterwards focus on retirement.

If you’re a Dave Ramsey fan, you’ll recognize this pattern as part of the total money makeover. Save – Spend – Give will be your final state.

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