Enlightened Capital Blog

Is it better to pay off your debt early or invest?

This is one of the most common questions in personal finance and a question I’ve spent too much time thinking about! You should base your decision on two factors: the interest rate on your debt compared to your investment options, and your time horizon/risk tolerance. These factors are all related, as your risk tolerance will relate to how long of a time horizon you have. Let’s look at each of these factors individually and I’ll talk about how I use this framework for my family’s financial planning.

What is your opportunity cost?

 The best way to make investment decisions is to compare the risk and reward of all your available options. In practice, this means comparing the interest rate on your debt to the expected return of the investment options you have, such as cash, bonds, stocks, and real estate.


Currently cash and bonds offer relatively unattractive expected returns. The best rate I could find for a high yield savings account is 0.9%. For bonds, look at how low rates are for treasury bonds with different maturities. The chart shows that the yield on a 10-year Treasury is 0.71% and the yield on the 30-year Treasury is 1.45%.While there are other fixed income asset classes  besides Treasuries, most high quality bonds are yielding under 2% as of 9/10/20.

Yield Curve 9.9.20
Source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield


Whatever debt you have outstanding should have a higher interest rate, which means that you can guarantee yourself a higher rate of return by paying down your debt instead of keeping your money in a high yield savings account or buying Treasury bonds.

In terms of equities and real estate, you can use the information I provided in my asset allocation primers to estimate an expected return for equities and real estate. Currently, I expect the S&P 500 to return at best 5-6% (nominal) over time, and most real estate closer to 4-5% (nominal) over time.

Then compare the interest rate on your debt to these available options. The higher the interest rate on your debt, the more attractive it will be to pay off your debt rather than invest. Because paying down your debt early guarantees you a rate of return, I only recommend investing in other asset classes if you expect to earn a higher rate of return. For example, if the interest rate on your mortgage is 4%, then you would want a higher expected rate of return to invest in another asset class, maybe 5-6% depending on your risk tolerance.

What is your time horizon and risk tolerance?

Related to expected return is the time horizon for your investment decision. Returns for the S&P 500 are highly volatile from year to year but returns tend to smooth out when looking at longer periods of time. The chart below shows the total return on the S&P 500 on an annual basis going back to 1929, and you can see how much fluctuation there is year to year. As a result, paying down your debt and getting a guaranteed rate of return, may be a better option over shorter time horizons.

Annual SP 500 Total Return

Source: https://www.macrotrends.net/2526/sp-500-historical-annual-returns

Even over a 10-year time horizon the S&P 500 has generated negative total returns. You can see the 10-year rolling return was negative in 2009 and before that in 1939/1940. The S&P 500 has also generated rolling 10-year total returns below 5% for most of the 1970’s and most of the 2000’s. As a result, even with a 10-year time horizon you could see substantial volatility in your returns from investing in the S&P 500 or another equity index.

Rolling SP 500 10 Yr Return
Source: https://www.crestmontresearch.com/docs/Stock-Rolling-Components.pdf

Over longer time horizons, you have a greater ability to withstand equity market fluctuations. If you plan on retiring in 5 years or less, then you would likely have a lower risk tolerance than someone with a 30-year time horizon. Ultimately, it is up to you to decide how much risk you are comfortable with over a given time frame. As we saw in the above charts, the stock market tends to be extremely volatile from year to year but not nearly as volatile over longer-time horizons.

However, one mistake I frequently see in these types of articles is the assumption that historical equity returns will continue going forward. Many financial advisors assume an 8-10% annual return in equities, in which case why would you ever pay off your debt early? First, past returns are no guarantee of future results. Personally, I expect equities to generate returns closer to 5-6% over time, due to how high equity multiples are currently. The below chart from Absolute Return partners compares the current P/E multiple of the S&P 500 to the returns generated over the next 10-years. The current P/E multiple of 28.7 is literally off the below chart and implies a negative annual rate of return over the next 10 years.  

Startng PE multiple compared to 10 Year Returns
Exhibit 3: Starting P/E Multiple on S&P 500 vs. Ensuing 10-Year Returns
Data from January 1995 to September 2016. The chart was produced in late 2016 so ignore the suggestion that the current multiple is 16.3.
Source: Alger.

Additionally, Boston based investment manager GMO expects negative annual returns for many asset classes over the next 7 years, assuming P/E multiples revert back to historical norms.

GMO 7 year forecast

I’m not sharing these charts to scare you, but instead to point out the benefits of earning a guaranteed rate of return by paying off your debt over shorter time horizons. GMO’s forecasts have been wrong in the past, but are still helpful to look at.

How I'm using this framework

In terms of my own family, we recently refinanced our mortgage and have close to 30 years left on our 10/1 ARM, with a 2.625% interest rate. The 2.625% mortgage rate is definitely higher than what we would earn in a high yield savings account or investing in Treasuries, but I expect we would earn a higher rate of return by investing in equities or real estate over time. However, we plan to retire well before our mortgage expiration, as we plan to be financially independent in the next 10 years. As a result, we are taking 50% of our extra cash flow each month to pay down our mortgage and using the remaining 50% to invest in equities in our brokerage account. Normally, we have an aggressive risk tolerance, with a 95% allocation to equities across our retirement accounts and brokerage account. But we want to have our mortgage paid off before we retire and are locking in a guaranteed rate of return by paying it off early.

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