Invest or Pay Down Debt?

Should I Invest or Pay Down Debt?

The question of whether to invest or pay down debt should be on the mind of every doctor. Although there is no one “right answer” for everyone, fundamental principles exist to guide this decision.

Let me start by saying that we support and believe in both investing and paying down debt. Both are good and can be financially healthy. Both require discipline and deferred gratification. In general, whether you pay down debt or invest, you’re getting ahead financially.

Although many paths may get you to your destination, based on your circumstances, some “routes” will get you there faster. The best course for you requires “financial imaging” and a customized “treatment plan.” Our goal for you is to help you reach your desired destination as quickly and securely as possible.

 

Investing and paying down debt, two sides of the same coin.

Both investing and paying down debt increase your net worth, which is calculated as follows:

                Assets

                (Liabilities)

                Net Worth

 

Which will give you the highest expected return?

Not only do both investing and paying down debt increase your net worth, but they also offer an “expected return.” When you invest, the return is the investment return you’ll get from the underlying asset: dividends and increased share price for stocks, or interest when you have a savings account or own a bond.

The “return” you get when you pay off debt is simply the interest saved that you would have had to pay if you didn’t pay off the debt. Interest on credit card debt can easily be as high as 30% annually. As such, smart doctors pay their credit cards in full each month!

An easy way to decide whether to invest or pay off debt is to compare the interest saved by paying debts to the expected return from investments. I recently met with a client who had an average 1.5% after-tax interest rate on his loans. Paying those early would have secured a meager 1.5% return on his money. Instead, we chose to make the minimum debt payment and invest the money where we expect a much higher ROI.

 

What risks do your debts pose?

The decision to pay debt or invest takes more than just investment return into consideration; you also need to consider the risks of both options. Investing your money comes with risk (e.g., getting a lower return than the cost of debt). Additionally, having debts can also add risk to your life. Those who experience high debt payments can relate to this risk.

At PFG, we quantify the risks your debts pose to you using two simple ratios:

• Assets-to-Liabilities Ratio: Assets ÷ Liabilities. This represents the number of times you could pay your debts if you liquidated all your assets. The lower this number, the more risk your debts pose.
• Debt-to-Income Ratio: Monthly Debt Payments ÷ Monthly Income. This represents the percentage of your income that goes toward paying debt. The higher this percentage, the riskier your debt situation.

 

Paying a loan off vs. paying a loan down.

When deciding to pay down debt or invest, specifically to reduce the risk posed by debts, keep in mind the big difference between paying a loan off and paying it down. Paying a loan “down” makes progress toward eliminating the loan, but you still have the debt. To pay a loan “off” is to get rid of it entirely. When you pay a loan off, the payment is gone forever.

There is a big difference. Think of a baserunner in baseball making progress toward second base versus arriving at second base. The progress is good, but until you get there, the risk still exists!

For clients with high debt balances and payments, we sometimes recommend saving money in a savings account until they have enough to pay an entire loan off. This approach allows them to maintain liquidity and reduce financial risk.

 

When is it riskier to pay debt than to invest?

Most people agree that paying down debt is a “safer” move than investing. However, there are situations when paying off debt can be riskier than investing:

• You have a profitable year and aggressively pay down debt, only to face a big tax bill and lack the cash to pay it.
• You aggressively pay down debt, but later need to borrow money for another purchase.
• You pay down debt, then face unexpected expenses (e.g., illness, disability, or another economic disruption) but lack liquidity.

One client of ours aggressively paid off a home loan (2.75%) and a practice loan (3.5%) and was happy to be debt free at an early age… until they decided to build their dream home on a large plot of land, now borrowing at rates of over 8%!

 

Investing and Paying Down Debt: Two Forms of “Paying Down Debt”

As mentioned earlier, investing and paying down debt are two sides of the same coin, meaning they both increase your net worth. They are also both forms of “paying down debt.” When it comes to debt, there are two terms you need to understand:

• Debt: The amount of money you owe because you have already borrowed and used the money. These debts appear on your statement of net worth (or balance sheet).
• Unfunded Liabilities: The money you owe for future expenses that you have not yet saved for. These include future housing, healthcare, travel, food, and other costs. Although they don’t show up on your balance sheet, they are real and they are there!

To put this into perspective, consider the U.S. Government. At the time of writing, the National Debt exceeds $35.97 trillion, equating to $272,820 per taxpayer. However, this is a mere fraction of total projected “Unfunded Liabilities,” which top $102.5 trillion. These include future military, pension, and Medicare costs, among many other things.

Some people are eager to pay off debt but reluctant to save and invest. Smart financial planning recognizes that paying off debt and investing are two sides of the same coin.

 

So, What’s the Answer: Pay Off Debt or Invest?

The simple answer is…both. Both can be good and are financially healthy. To answer this question generally, here is the priority of saving money:

1. Pay for a modest lifestyle
2. Acquire a suitable practice, including equipment necessary to reach your production potential
3. Pay for sufficient disability and, where appropriate, life insurance
4. Build a Working Capital Base in your business
5. Save an Emergency Fund (3-6 months of living expenses)
6. Pay off high-interest debt, including credit cards and student loans
7. Maximize contributions to Roth IRAs (for doctor and spouse)
8. Set up a 401(k) and maximize salary deferrals (for doctor and spouse)
9. Choose the next move:
   • Increase lifestyle spending (balance present and future needs)
   • Maximize the Profit-Sharing portion of a 401(k) plan
   • Pay off additional debt
   • Invest in a “taxable” investment account (no tax perks, just pure investing)
10. Save for kids’ college (retirement planning should generally take priority over college savings)

The priority when you get to step #9 is much more nuanced.

 

When Might You Invest in a Taxable Investment Account Before Paying Off All Your Debts?

Investing in a taxable investment account could be a better course than paying off all your debts under certain circumstances:

• You expect a higher investment return compared to the interest paid on your debts.
• Money in a taxable investment account is liquid and can be withdrawn without penalty if needed. While this account is not an emergency fund, its liquidity can make it safer than having no liquid assets and the same amount paid toward debt.

For example, consider the simplified Net Worth statements below; which of these would you rather have?

 

Both doctors have the same net worth ($100k); however, Dr. 1 has more liquid assets, which if something were to happen to him, would make this a “safer” financial position to be in than Dr. 2.

Final Thoughts

Investing and paying down debt will both increase your net worth. The best course for you will depend on your unique financial situation and goals. With proper planning, you can achieve a balance that provides both security and growth.