Paying Off Debt vs. Investing

by Paul R. Ruedi, CFP®

Savers often get stuck choosing between investing their money or paying off debt. There are many things that must be considered when making this decision, both the objective mathematical considerations and also the human emotional side as well.

If you use $100 to pay down debt that is accruing interest at 5%, thus saving you 5 dollars of interest, you are $5 better off. If you were to instead use that same $100 to invest and receive a 5% return, you are $5 dollars better off. Though one involves saving $5 in interest and the other involves earning that $5 as an investment return, it is functionally the same thing. It is mathematically optimal to put more of your dollars wherever you get the highest rate, whether it be avoiding interest or receiving a return as an investor.

When the gap is large the decision is obvious; for example an investment that returns 10% vs. paying down a mortgage at 3.5% interest. If you have credit cards accruing interest at upwards of 20%, it is probably better to pay those off than to invest at 10%. But people often get stuck when the rates they are choosing between are similar. In those cases, it may actually be better to simply choose whichever option makes them feel better.

Though on paper paying down debt vs. investing could be a purely mathematical decision, in real life there are practical elements that can take priority over the numbers. Debt often feels like a monkey on people’s backs and the constant feeling of being “in the hole” can be oppressive. It hangs over their personal finances like a dark cloud, which makes it difficult to celebrate any other financial successes that occur in life because they feel like moving pebbles relative to the boulder that is their debt.

Regardless of what the numbers say, it may be better for someone who is very stressed about their debt to pay down their debts before investing and get the mental reward of doing so. This will eventually turn to lasting peace of mind once the debt is paid off.

My job as a financial planner is more often to prevent people from acting on their emotions and pursuing a course of action just because it makes them feel better. But given the choice between empowerment or frustration as people start taking responsibility for their own financial well-being, the first option certainly is more likely to reinforce good habits and set someone on a path to financial success, even if it is a little mathematically sub-optimal.

Paul R. Ruedi is a Certified Financial Planner™ professional with Ruedi Wealth Management in Champaign, Illinois.