How to Become Rich - Pay Off Debt, Save or Invest?

From the desk of: Keelan Cunningham
Date: February 22, 2012
Re: How to Become Rich...

Should you pay off debt, save or invest?

This is a question people often find difficult to answer. So let’s take a look at these options and some factors to consider when deciding what to do with your surplus cash…pay off debt, save or invest. Ultimately, this will decide who becomes rich and wealthy in the game of wealth.

Recently, I was at a friend’s house party and one of my best pals and I got talking about debt, specifically mortgage debt. We were discussing whether he should put a lump sum toward paying off mortgage debt attached to an investment property or use his money for something else. The question was particularly apt as the value on this house had depreciated by c.40% over 2 years and was now in substantial negative equity.

Putting in Good Money after Bad

My take on it was that it makes no sense putting in good money after bad. If the debt we were talking about was non-mortgage debt (e.g. very high-interest credit card debt) then I’d have said pay it off pronto. But we weren’t. The way I figured it was, since the interest rate he was paying on his house is 4%, if he could get greater than a net 4% return from his investments than he was better off.

Paying Down Debt is a Sure Thing But...

One way of looking at the 4% mortgage interest is that if you don’t have to pay it you are essentially getting 4% net on your money. This is the equivalent of 5.2% pre-tax money (rounding off his effective tax rate to 30%)

Sure, paying down debt is a sure thing; there’s a certain comfort that comes from paying off debt. If this house was his home (his primary residence) and he lived there with his family and he absolutely loved the house, and his neighbourhood, and his kids went to school around the corner than my answer to him would have been different. So, the answer to the question of whether you pay off debt first or invest is not a straightforward maths question.

Savings Are Yours to Keep

It’s difficult to argue that paying off debt is not necessarily the right thing to do when jobs are not secure, house prices are down etc. It’s an understandable reaction but it’s important to note that it may not be the best for you financially. One thing I wouldn’t advocate is using savings, retirement savings or emergency funds to pay down mortgage debt. I think you need a minimum of 1 year’s income put aside in liquid cash for yourself and your family and for no one else to get their grubby little hands on...no matter what! And rather than hand over your savings I think you’d be better off investing so as to beat the cost of the debt you’re paying elsewhere. Ultimately, you can’t save your way to wealth so you got to be investing.

In Summary...

Whether you choose to pay off debt first or invest is really a question of priorities. You’ve got your priorities and they i.e. lenders have got theirs…they’re usually different. In the case of high-interest personal loans then it is a good idea to pay down the debt fast. The bank will always see it as your priority to give them all your hard-earned money. Ultimately, it’s a question of understanding who it is that is getting more wealthy...them or you. The choice is yours!

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