Paying Off Debt vs. Investing in this Economic Environment

by Kevin on October 8, 2008

I’ve been pondering this debate for a few weeks. If you have debt, should you be paying it off or investing for the future? The markets have tanked roughly 37% since October of last year. Is there a buying opportunity there or do the markets have room to fall more?

This is a blog about living a debt free life.

Naturally, you should expect my answer to be pay off debt. My No Debt Plan is designed to get you out of debt before you start investing heavily. Step 4 is Pay Off All Consumer Debt. I haven’t even gotten to the investing step of the No Debt Plan. I am very anti-debt!

“But the markets are so far down, shouldn’t I be putting money in now?”

I will grant that point. The markets are down. Way down. Waaaay down.

But putting money in only when the market looks down, or looks up, or looks flat, or whatever “trigger” you want to use is called timing the market. It has been proven that if over the last 70 years or so, if you missed the 25 best days in the market, your returns were severely hampered.

Ramit Sethi of iwillteachyoutoberich.comhas a book coming out and mentioned this on his blog today:

Recently, a group called Dimensional Funds studied the performance of the S&P 500 from January 1970 to December 2006, during which time the annualized return of the market was 11.1%. They also noted something amazing: Of those 36 years from 1970 to 1986, if you missed the 25 days when the stock market performed the best, your return would have dropped from 11.1% to 7.6%, a crippling difference.

That’s a 3.5% annualized return difference against timing the market. Over 36 years that is bound to be a ton of money you’ve missed out on. Timing the market is impossible. On a daily basis it is a coin toss on whether or not the market will go up or down that day. So what should you do?

Have a financial plan

Planning, planning, planning. I’m all for planning. A well thought out plan pretty much answers all of your financial questions for you — and it answers this question, too.

I’m not saying you have to follow my No Debt Plan down to the very specifics. If you think you should continue to invest regardless of the market while paying down debt at a slower pace, then stick with your plan.

If I were in debt right now, it would depend on the level of debt for me to make a decision. If I were thousands of dollars in debt, I would probably limit my investing to small amounts — but I would keep investing. If I could knock out my debt in a few months, I would knock it all out as soon as possible.

Debt repayments are good returns

While the market has fallen 37% over a year, if you made debt repayments you are earning a positive return. Let’s say you have a credit card with a 15% interest rate holding a large balance. For every dollar you pay off, you are earning a significant return because you are eliminating interest. You can’t retire off of eliminated interest payments, but it helps you get out of debt faster (and thus move on to investing faster).

My general advice: pay off your debt as quickly as possible, then develop an investment plan.

What do you readers think? Are you in debt and continuing to invest heavily? Have you changed strategies recently from debt to investment or vise versa? Leave a comment and join the discussion.

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{ 16 comments… read them below or add one }

Kevin Wright October 8, 2008 at 12:19 pm

I think the first thing you need to do is have a workable emergency fund. I’d start with $1,000.00 and then slowly build it and bust out my credit card debt. You can’t get to worked up on those 25 days. That is a small percentage of the total days in the period you mentioned. The chances of hitting that are not very good.

But this advice is for people who are really just getting started, like myself. We really need fundamentals established in order to move forward.

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Kevin October 8, 2008 at 6:32 pm

@Kevin: Definitely agree on the emergency fund. In fact, it is step 3 of the No Debt Plan — right before paying off debt.

The 25 days is a small percentage of the period — that’s the point. If you think you can time it so that you hit all of those days (and miss the down days) you are a much better investor than I. The chances of hitting that are not good; the chance of missing it is really good.

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Start-Up October 9, 2008 at 10:18 am

I personally think it is a great time to invest. Yes, the market could drop even more, but the stock prices are severely depressed already. I don’t consider investing money at depressed prices market timing, as long as what I’m investing is for the long term. Market timing is switching between investments and cash frequently, at least that’s my definition.

As for paying down debt vs. investing, I think it depends on the interest rate of the debt. If it’s credit card debt with huge interest rates I would pay it off rather than invest. I have a car loan that carries a 3.9% interest rate, I would rather invest the money in the stock market than pay it off early.

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Russell October 9, 2008 at 12:14 pm

Isn’t it funny how people react to the stock market indicators. Last night I took a drive into town and saw several signs for gasoline prices. It was nearly 25 cents less than when I last bought fuel on Saturday. My first thought was, I’m not buying any of that gasoline, it’s not worth as much. And what’s worse, I have a car and a motorcycle back home full of gasoline that is now worth less. I’m not buying any more gasoline until the price gets back up where it’s has value.

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Kevin October 9, 2008 at 7:27 pm

@Start-Up: Ooo, 3.9% would be a tough call for me between paying it off or continuing to invest. Would need to look at the full picture.

@Russell: Excellent analogy!

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Anna B October 10, 2008 at 12:42 pm

So, I am in this conundrum as well…I took a loan last summer on my 401k to do some repairs on my house and pay off some other high interest debt. The interest rate on that loan is 8.75%. I am in the process of selling half of my duplex to my parents. With the money, I planned to pay all debts first before paying down my mortgage. (5.85%) With the way the rest of my 401k is dropping I am starting to think of that loan as a guaranteed rate of return as well as a protection for my money. I could also refi it at the current rate of 6%.

I really wanted to be out of debt, but with the way the market is tanking I am thinking it might be better to hang on to this one until the market is stable. But I could also look at it as getting back in when the price is low…

What would you do?

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Kevin October 12, 2008 at 12:43 am

@Anna: Not sure I completely understand your situation. Let me send you an email to get clarification.

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David Snow November 15, 2008 at 2:50 pm

Martin Zweig was one of the best investors on Wall Street. His 1986 book “Winning on Wall Street” was a simple timing model that was based on two models:
1. The “monetary model”. Simply put – If the Fed is trying to slow the economy down by raising interest rates, the will succeed at some point – so don’t bet against them
2. A “momentum model”. Simply – What direction was the last weekly 4% swing in the market, follow that trend.

This model has saved my put during 1987, and this year. If I had been paying attention to the model during the tech bubble, it would have saved me then.

Basically the rules are:
1. Be in money markets when the indicators are negative
2. Be in diverse funds when the markets are positive.
3. Stay where you are when the model is neutral.

I when to cash 15 months ago and my IRA and other investments are positive for the year. No many people can say that this year.

/DaveS

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Personal Finance Firewall February 17, 2009 at 4:25 pm

This is something that I have struggled to decide over. My wife and I have been talking about whether we snowball our money at investments or snowball it at debt. I think we will hit the debt as hard as we can then once its gone, get into some low risk investments.
Nice post, very informative.

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Cathy February 21, 2009 at 7:22 pm

In some cases, just budgeting for both seems like the wisest way to go. The only CC debt I have is at 1.9% interest/yr for the life of the loan and is budgeted to be paid off in 12 months. This allows me a budgeted allotment for savings which I’m investing.

By contributing the max to my 403B, the tax savings easilly justifies the 1.9% cost of the CC debt. In that account I my goal is to dollar cost average in to the same funds that went down 40% last year. In doing so, I’ve managed to work myself up to being only 20% down in half the funds. This means I should recoup that 40% faster when the market rebounds.

Hopefully, I am also taking advantage of decent gains by buying “Best of Breed” stocks at a huge discount in my Roth IRA. These are stocks I could not afford to buy a year ago and will hpefully pay off in the future.

I don’t necessarily agree with theories of just paying down debt first. What really helped me reach my goals and move closer to being debt free is when I started saving. Psychologically it really does something for you. When I was just paying down debt, it was like being on a diet, constant deprivation and little to show for it, resulting in binges. When I started saving, it was really gratifying to see my savings grow at the same time my debt was shrinking and now all I can focus on in how much more I’ll be able to “save” once my debt is paid, so it becomes self-reinforcing.

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Kevin February 21, 2009 at 11:30 pm

@Personal Finance Firewall: Thanks for stopping by. I think everyone needs an emergency fund first, then knock out the debt. It really helps to have something to show you how much interest you are saving with each dollar added to the principle. I’m trying to come up with something like this that will show how much you’re saving. Really inspiring.

@Cathy: Excellent point about the dieting. See my point above — perhaps having something to show your “equity” growing in the debt (less interest paid than without paying off early) would help?

Congrats on the DCA. Hopefully it pays off for all of us soon…

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dan April 24, 2009 at 12:01 pm

The question is not should I pay off debt or invest? The question is better put, should I pay off this particular debt or invest?
And the answer to that question depends on the interest rate of the debt. If its a credit card at 15% like in the example, by all means pay off the debt.
But if its a mortgage at 5% with a tax deduction, by all means invest.
Even if you suck at investing, you should be able to do better than 5%.

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dan April 24, 2009 at 12:03 pm

Good post Cathy

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Beth January 14, 2010 at 5:25 pm

I have a 401K that I rolled into some IRA’s when I left my previous employer. Currently am not contributing to any retirement accounts, mainly because I have not had sufficient income. I’d like to get rid of my debt, about $30,000. Would it be worthwhile to do that and then use the money I was otherwise using to pay debt to build back up my retirement savings?

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Finance February 8, 2010 at 3:58 am

I personally think it is a great time to invest. Yes, the market could drop even more, but the stock prices are severely depressed already. I don’t consider investing money at depressed prices market timing, as long as what I’m investing is for the long term.

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Finance February 8, 2010 at 4:01 am

I really wanted to be out of debt, but with the way the market is tanking I am thinking it might be better to hang on to this one until the market is stable. But I could also look at it as getting back in when the price is low…and that is why I hardly get out of debt.

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