Written by: John Neri
As a financial planner, we are asked many questions about personal finance. These questions can be as basic as how much money should I keep in my emergency reserve account, and as complex as I have $100,000 saved and want to retire next year, what should I do. One question that arises more than all is, “Should I pay off debt or invest the cash on hand I have?”
There are many rules of thumb when it comes to paying off debt, or deciding that investing is a prudent use of your money. They range from what feels best emotionally, to what makes the most sense logically. Rather than overcomplicating things, we like to simplify this question by letting people know that the answer is simpler than they may think.
The 7% Rule
As we navigate this question, we are big fans of teaching prospects and clients our “7% Rule”. The 7% rule is our line in the sand between whether a debt is good or bad. I know it seems silly to think that there is such a thing as a good debt, but if you look at it through the right lens there can be such a thing.
What we generally recommend is to pay off any debt that carries an interest rate higher than 7%, and to pay the minimum on debts with an interest rate below 7%. With this understanding of how to approach debt, we tell clients to line up their debts from highest interest rate to lowest interest rate, and to pay off the highest interest rate debt first, and to work their way down the list regardless of the size of the balance.
This rule did not come out of nowhere we had to have empirical evidence that supports why this makes sense before we could stand behind such a statement. If you look at how the S&P 500 Index has performed since 1926 until 2018, that index has averaged around 10%. Then why not make the rule the 10% rule?
Well first off, past performance is not indicative of future returns. Also, that does not factor in inflation which has averaged around 3% over the last 100 years. Keeping those factors in mind, we like to standby our 7% rule as it bakes in a margin of safety.
A good example of where we would encourage someone to pay off debt first vs. investing would be considering either a personal loan or a credit card. Those debts carry an interest rate around 10-20%. If we think about the 7% rule, those debts are much higher so you should likely focus your time and energy on ridding yourself of those debts first.
Occasionally, I get asked why not invest when you have high interest rate debt? While there are years where the market can exceed a 7-10% return (take 2021 for instance, the S&P 500 returned a whopping 26.9% in 2021). We like to remind people that while we will never complain about market outperformance, it is not something that should be expected / guaranteed.
I would much rather take a 10-20% guaranteed rate of return by paying down those higher interest rate debts, than gambling and hoping that my portfolio outpaces the interest accruing on my debts.
Remember how I said debt could be viewed as a good thing? Let’s take an example of someone who has an auto loan of 2%, no other debts, and money in the bank to pay this off in its entirety. Why not pay off the auto loan, and no longer accrue anymore interest, be done with having monthly payments, and be debt free?
The reasoning behind not paying off this car, has to do with a concept known as opportunity cost. Your options are to either get a guaranteed rate of return of 2% by paying off that auto loan so future interest no longer accrues, or you could get a 7% rate of return in the stock market. Still not comfortable with investing in the stock market?
Remember how I said inflation averages around 3% a year? If you have a 2% auto loan and inflation is averaging 3%, inflation is essentially paying off that auto loan for you, further supporting the idea of considering investing.
Historical Performance of Stock Market Returns
The stock market carries inherent risk, right? It absolutely does, but how much risk, depends on your investment allocation and more importantly how long you leave that money invested before you cash out that investment. If you look at the historical performance of the S&P 500 from 1926 until 2018 you would see the following data (assuming dividends were reinvested):
- The index is positive 75.2% of the time over a 1-year time period
- The index is positive 87.7% over a 5-year time period
- The index is positive 94.7% over a 10-year period
- The index is positive 99.68% over a 15-year period
- The index is positive 100% over a 20-year period
What’s the takeaway?
That while the market does carry inherent risk, the longer you stay invested the better your chances are of success. I generally try to stay away from gambling, but with odds like that, it gives my clients and I peace of mind that if you stay invested good things tend to happen.
Now, this doesn’t mean that if you have a debt below 7% that it is a bad idea to pay this off. In fact, there is data that shows that it can be emotionally uplifting to do so and gives you a sense of accomplishment when you are able to pay off a debt.
For example, if someone has a sizable mortgage balance at a 3% interest rate, and they have a small 1% auto loan balance it may feel better and be more empowering pay off that auto loan completely and have that out of your life. If that encourages you to continue your journey towards becoming debt free, I am all for that.
Your thought process approaching debt moving forward should resemble something like this:
- Is my debt above 7%?
- If yes, you will likely want to pay that debt off.
- If your debt below 7%, then you could consider investing extra cash on hand. Or if you would like to pay off that debt, you need to ask yourself: Do you feel confident that the stock market will outperform the cost of the debt?
- If yes, you should consider investing that money, if you do not feel comfortable with the stock market / it would be more empowering to you to have the debt out of your life, then pay off the debt.
- Is my debt above 7%?
Should I Invest or Pay Off Debt?
In summary, there is no one size fits all approach to tackle debt because debt carries an emotional component to it. With debts carrying a high interest rate, it can be beneficial to get those out of the equation. With debts below 7% interest, I would encourage you to take some time to figure out what the logical choice is, and factor in the emotional choice, and consider how that would impact your mood and progress towards your goal of becoming debt free. Whichever is more appealing, pursue that option and stick with it.
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Investing involves the risk of loss, including total loss of principal. Past performance is no predictor of future returns. This should not be construed as individualized investing advice. Consult with your investment advisor to develop an appropriate investment strategy for your circumstances.
Disclosures: Investments involve the risk of loss, including total loss of principal. Consult with your financial advisor before making any investment decisions.