Maybe you’re freshly out of school and saddled with student loan debt. Or maybe you’ve been working for years and just bought your first house. Whatever your situation, there is a good chance you may be in debt for something and have loans to pay down.
Meanwhile, you keep hearing, “the sooner you start investing, the better off you will be! Compound interest is the seventh wonder of the world! Don’t wait – start now!”
While this is true—compound interest is a powerful force and you may be amazed how much money you begin to accumulate once your investment accounts start taking on the snowball effect—you are probably wondering, “What about my debt? If I invest more money now, then I have less money to pay down the principal on my loans, which means I will ultimately pay more interest over the life of the loans. So which is the better option—pay down my loans or start investing now?”
There is actually a very simple, general rule of thumb to help you frame this decision. Let’s call it the “Highest Rate Rule”. It goes like this:
If the rate of return you are likely to earn by investing is greater than the interest rate on your debt, then it makes sense to invest the money and make the minimum payment on your loan. If the interest rate on your debt is greater than the returns you are expected to earn by investing your extra income, then it makes sense to pay down your debt quicker. Additionally, If you have more than one loan at different interest rates, then you should pay off the loan with the higher interest rate before paying off the lower interest rate loans.
Simple, right?
Let’s give an example.
You are fresh out of college and just started working. You have $50,000 in student loans at an interest rate of 5%. You are thinking about investing for the long term in a passively managed, low-cost mutual fund of stocks that you expect to return an average of 7% annually. In this case, it would make sense to invest and pay the minimum on your student loans, as your investment in the mutual fund is expected to grow at a faster rate than the interest on your loans will accrue.
It is important to keep in mind, though, that investment returns are never guaranteed. If you choose to pay down your student loans with your extra income instead, you are effectively earning a 5% return on your investment compared to the interest you otherwise would have had to pay. However, if you choose to invest the money, there is always a chance that your investment will have a lower average rate of return than expected. So in a way, your decision comes down to a 5% guaranteed “return” versus an uncertain, but expected, 7% annual return.
Another important factor to consider is how soon you need the money. Let’s use the same example. Maybe in the long term—let’s say 20 years—you expect the mutual fund to return the same average 7% per year. But maybe you are saving for a down payment on a house, and you don’t want to wait 20 years. Maybe you want to do it in 5. Well, investing in that mutual fund is much more risky in this case. The stock market goes through trends all the time. What if a bear market is just about to begin, and your mutual fund investment is on the decline? In five years, your investment may just be breaking even, or it may even have a loss.
In this case, it might make sense to invest in something like a Certificate of Deposit (CD) or a money market account (MMA) and earn a much less risky, lower rate of return for five years, while making your minimum loan payments. Your net worth may be less than if you used all of your extra income to pay down your loans, but if you did, you would not have any cash available for your down deposit!
Remember, the Highest Rate Rule is just a general rule of thumb, and not an absolute law to always follow. It is important to consider your personal situation and your current financial goals. But if your goal is pure net worth growth as quickly as possible, then this rule is the golden rule.