The decision of whether to use extra money to pay down your debt more quickly or to instead invest it for potentially greater overall returns could have an immense impact on your future financial state and thus should not be taken lightly.
The first couple pages of Google search results for “pay off loans vs invest” contain articles almost wholly in favor of paying down the higher-interest rate debt first but paying just the minimums on lower-interest rate loans such as student loans and mortgages, while investing the rest in the stock market.
Is that really the best choice? Maybe. But many of those aforementioned articles make stock market investment returns sound far more rosy than they are due to oversimplification. I’ll explain how to make a more realistic prediction (though in the end, stock market returns are determined by chance) then tell you what I recommend as a rule of thumb.
Important Factors in Measuring Investment Return
The effects of taxation, inflation, fees, compounding, and historical return should be taken into account when estimating returns on any investment.
The amount of taxes you would incur from investing in the stock market depends on multiple factors such as your investment type, whether you’re investing from within a tax-sheltered account, how long you hold the stock shares for, your tax bracket, and the state you live in. Figure in taxes for your situation, and remember that though investing from within a tax-deferred retirement account like a 401(k) or traditional IRA means you won’t be paying taxes on earnings likely for many years, you’ll still be taxed upon their withdrawal. Also consider the short-term vs long-term capital gains tax rate, which I explained in How to Estimate Your Investment Return.
Payment of student loan interest may cause you to be eligible for a deduction of taxable income. Specifically, you may deduct a maximum of $2,500 of both required and additional interest payments. Your deduction eligibility is gradually reduced and eventually eliminated by phaseout as your modified adjusted gross income (MAGI) increases to the annual limit for your filing status, dependent on your tax bracket.
The “real rate of return” is the inflation-adjusted return, whereas the “nominal rate” of return does not factor inflation in. It was about 3% throughout the 1900s, but the Federal Reserve Bank of Cleveland’s latest estimate of 10-year expected inflation is 1.90%.
As for fees, here are a few recent estimates for an idea of what to expect for mutual funds and exchange-traded funds, popular investment vehicles:
• The 2016 Investment Company Institute Factbook states that average mutual (including both actively and passively managed) fund fee was 0.68%.
• According to Vanguard, the industry average ETF expense ratio is 0.53%, while Vanguard’s is 77% lower, at 0.12%, as of December 2015.
• A 2016 Motley Fool article reports that the average expense ratio of index funds was 0.11%, and 0.84% for actively managed funds.
The proper measure of average return for an investment whose dividends you’re reinvesting is the compound annual growth rate (also termed annualized total return or geometric average). This value is usually a percent or two smaller than the arithmetic mean/simple average.
Risk is a vital factor to consider when comparing investment returns and is particularly salient in the context of deciding whether to put additional money toward debt or investing.
There are many ways you can mitigate your risk in investing in stocks. Diversifying your portfolio reduces risk, which is a major benefit of investing in mutual funds and/or exchange-traded funds (ETFs). Since you may have hundreds of stocks and other securities, you may barely notice a change if one drops substantially in value. But the value of your stock shares could slowly build for many years then suddenly plummet, as many investors experienced during the economic downturn of 2008.
The “return” from paying off student loan debt is guaranteed and thus has zero risk, which is a huge advantage it has over investing. Given that, the expected returns from investing in the stock market should be significantly greater to justify that added risk.
There is no clear cut number at which that would be the case.
Average Historical Returns
In the invest-instead scenario, let’s assume you’re going to invest for the long term and will reinvest your stock dividends.
From 1871 through 2016, the after-inflation compound annual growth rate (also called the annualized total return, and which assumes reinvestment of dividends) of the S&P 500 was 6.88%.
However, the stock market has demonstrated inconsistent results, with huge fluctuations over shorter time frames. Driving that point home, a chart published by the New York Times illustrating the average annual real return of the S&P 500 index every year between 1920 and 2009 demonstrates how fickle market returns have been.
Given their volatility and the fact that past performance is not predictive of future results, average historical stock market returns should be taken with a grain of salt; while history indicates that the odds of winning are tilted in your favor over the long term, investing in the stock market is a gamble with no guarantees.
For starters, stock market investment returns aren’t guaranteed—your investments may even lose value. But if you were to earn the historical inflation-adjusted average compound annual growth rate of 6.88% of the S&P 500 mentioned earlier, taxation and fees would cut into your return.
I recommend putting your additional income exclusively toward debts with an interest rate of 4% or above, prioritize debts with the highest interest rates first (the debt avalanche method).
Once you’re left with debts with an interest rate of under 4%, I’m slightly in favor of putting $1 toward investing for every $1 you put toward your debt from that point forward. If you want to just pay the minimums due and invest the rest, that’s probably a solid option as well. Or if you really hate being burdened with debt and the fact you don’t know exactly what you’re going to make (if anything) in the stock market whereas you’ll be paying that interest no matter what, I’d encourage you to extinguish your debt as quickly as possible to free you to invest more.
An exception is if you have an employer match. My workplace doesn’t offer a 401(k) plan. If it did and offered an employer match, I’d jump on that opportunity and invest up to the employer match threshold; that’s a 100% return on your investment.