Is it better to pay down debt or invest?
Every now and then you might find you’ve got some extra money. Maybe you got a bonus at work, some overtime pay, a raise, a gift, or a tax refund. Whatever the source, having money you weren’t expecting presents opportunities. What you choose to do with it is probably driven by some combination of rationale thought and emotions.
One of the common questions in personal finance is, “Should I pay down my debt or is it better to invest my extra money?” If you’re being purely economically rational, you can calculate the answer to this question using interest rates as inputs. However, it’s a proven fact that humans are not always rational, especially when it comes to money.
When interest rates were really low, the decision to pay down your debt or invest in the stock market was easier to make. The long-term return on the North American stock markets is about 8% per year. This means that if you are investing for many years, like five or more, you could expect to earn about 8% per year on average*. Some years will be better, some will be worse – but if you average it out, 8% has historically been the average. In the low interest rate world of yesteryear, if you could earn 8% on the money you invested while paying just 3% interest on your mortgage, economically this made complete sense.**
Now that interest rates have risen, the economic trade-off between debt paydown and investing is not as great as it used to be. In this environment, another factor becomes more important: your emotions. For a lot of people, paying down debt is hugely satisfying and freeing. Many of us were told by our parents to pay down our mortgage as quickly as possible and it’s hard to shake that message.*** How much are these feeling worth? When rates are 3% and stock market returns are 8%, you might be willing to sacrifice debt reduction-induced happiness because the financial payoff is worth it. But a mortgage at 5%? Now the trade-off isn’t as attractive.
From a purely financial perspective, you can find the break-even rate that will help you make a decision. A break-even rate is the point at which both decisions are financially equal – you pay as much interest as you would earn. Using an online calculator, you can see that if your mortgage rate is 5%, you need to earn at least 5.12% on your investments, assuming you don’t have to pay any tax, which would be the case if you put money in a TFSA.
That’s all very technical, factual and emotionless. But decisions about money are definitely not emotionless. Although a big part of managing your money is about the numbers, equally important is how you feel. And you want to feel good.
Can you put a price on your emotions? No, but let me offer a guideline. If the interest you can earn on an investment is at least 1 to 2% higher than what you are paying on your debt, then maybe investing it is the right choice. If you have a mortgage at 5%, it probably makes more sense to invest in the stock market at 8%. Paying down a car loan at 7% is tricker - would the potential 1% difference you could earn by investing be worth holding onto debt that is dragging you down emotionally? Credit card debt – which normally runs you 18% to 21% - should always be paid down. There’s no investment that will give you that kind of annual return.
As always with financial planning, there are exceptions, complications and what-ifs. These days, the Financial Planning Canada Standards Council suggests using 6.3% as the expected rate of return on Canadian stocks. Using this lower rate changes your calculations. Another consideration is related to taxes: if you are able to deduct some or all of the mortgage interest on your property – because you rent it out or work from home – you need to consider the benefit of that deduction. Also, if you are in a high tax bracket and your investments are not sheltered in an RRSP or TFSA, your break-even rate will be higher.
For most people though, using a simple (and unscientific) guideline strikes a balance of taking a purely financial view and accommodating your emotions about paying down your debt. If you’re someone who is indifferent about debt, consider using an online calculator like this one to determine which you should choose. If you’re someone who cannot stop thinking about their debt, then skip the calculations altogether and just pay it down.
*The Canadian stock market has actually returned 9% on average per year over the past 50 years.
**Note though that this doesn’t usually work with GICs. When the interest rate on your mortgage was low, interest rates on GICs were lower, making paying down the mortgage a better option. You need to earn higher returns, and the stock market is the place to do that.
*** Keep in mind that our parents experienced double digit mortgage rates. In 1982, the five-year fixed rate was 19.2%, making paying down the mortgage by far the best choice.