The decision to pay off debt or invest is a personal one that depends on a lot of factors: risk tolerance, your number of income streams, liquidity needs, family expenses, job security, investing acumen, retirement age, inflation forecasts, and bullishness about your future in general. I’ve had hundreds of people ask me this question over the years, and I’ve also struggled to figure out a good guideline for myself. As a result, I’ve been racking my brain to figure out a viable solution that can be used by many.
The solution I’ve come up with is called, “Financial Samurai’s DAIR” or “FS DAIR” for short. The idea is to come up with something easy to remember, challenging, logical, and effective, much like the 1/10th rule for car buying to help folks maximize their wealth. Even though plenty of people have objected to my 1/10th rule for being too restrictive, I strongly believe the rule has helped people minimize financial regret and boost the incredible feeling of progress and financial security.
Since we are all CFOs of our finances, we need to figure out the most efficient use of capital. My goal is to make personal finance simple so ACTION can be taken. All talk and no action leads to nothing. I’d like to “DAIR” you to follow my debt pay down rule to achieve financial freedom sooner, rather than later.
SOME BASIC BACKGROUND ON INTEREST RATES AND RETURNS
Stocks have historically returned as little as 1% in the 2000s to as high as 19.58% in the 1950s. The average since the 1900s is 6-8%. Debt, on the other hand, is a little more difficult to track. We know that the 10-year yield has come down from 14.5% in the mid 1980s to under 3% today. The 10-year yield is a great barometer for mortgage interest rates. But credit card interest rates have stayed stubbornly high all these years from 17-19% in the 1970s to still around 13%-15% today for good creditors.
When times are good, you generally want to invest more money and leverage up. When times are bad, you want to reduce exposure to riskier investments and improve your financial security by paying down debt.
Finance is very Yin Yang. Nothing happens in a vacuum. If incomes, the stock market, and inflation all start going ballistic, the Fed will raise interest rates to contain inflation and stocks will fall, at least in the short run. If we’re in a protracted bear market with falling stock prices, deflationary income and rising unemployment, the Fed will lower rates to stimulate the economy through more borrowing. This is exactly what the Fed did after the dotcom bubble burst in 2000, which lead to a rebound in the economy. Unfortunately, the Fed’s actions also created another bubble in housing. Using monetary policy to tweak the economy is not easy.
You can view interest rates as a REFLECTION of inflation. Tell me the interest rate on a savings account or CD comparable from any country, and I can tell you the country’s nominal interest rate within a couple percent. For example, a couple readers have commented that they are investing in 9% returning savings accounts in India. That’s an incredible return since savings rates in the US are under 0.5%, and 5-year CD interest rates are under 2.5%. But the reason why Indian savings accounts are returning 9% a year is because nominal inflation is running at least 7% a year! The real return is therefore only 2%. There is no free lunch.
The real interest rate is calculated by simply subtracting the nominal interest rate by the nominal inflation rate. If you are getting a 100% raise a year, but all your costs are going up 100% a year, you’re swimming in place. This was the biggest complaint my Chongqing cab driver had during our hour long discussion from the airport to the hotel. His income was rising 30% a year, but food prices were rising 40%.
For more clarity, I argue why the best time to buy property is when you can afford to do so. Given property values are generally multiples higher than people’s incomes, property values will eventually become unaffordable for more and more people if income doesn’t grow much faster than property price inflation and/or if interest rates don’t come down enough. For example, if a $1 million dollar property increases by 3% a year and your $200,000 a year income also increases by 3% a year (a common scenario in SF), you are actually falling behind by $24,000 a year! You have to increase your income by 15% a year just to keep up.
If you believe interest rates will be rising, then your existing debt becomes “more valuable.” For example, let’s say you are borrowing at 3%, but comparable loans rise to 10% in three years. The value of your debt to youself and others increases because other people would be willing to pay you more for the ability to borrow at 7% lower interest rates. In terms of investing, if interest rates rise to 10% then your investments should aim to return a level of 10% or higher to compensate you for the risk you will take (equity risk premium). Otherwise, you can just lend out your capital, which entails its own risk.
If you believe interest rates will stay stagnant at these low levels or decline, then you should be more inclined to pay down debt and invest in equities given the opportunity cost or hurdle rate to invest in equities has declined. For example, let’s say the interest rate on a 5-year CD drops to 1% from 4%. 3% yielding stocks start looking more appealing now, and you should probably allocate more of your savings to such securities. An easy rule of thumb I use is to start asset allocating more into equities when the S&P 500 dividend yield is equal to or greater than the 10-year yield.
If any of these examples do not make sense, please let me know because understanding how interest, inflation, debt, and equity returns relate is very important. There won’t be a 1:1 correlation, but there definitely is a relationship over time.
THE FINANCIAL SAMURAI DEBT AND INVESTMENT RATIO (FS-DAIR)
Now that you’ve got a basic understanding of the correlation between interest rates, inflation, and investment returns, I’d like to introduce a pretty dummy proof way to figure out how to allocate each dollar saved towards debt pay down or investments.
The percentage of one dollar you should consider allocating to paying down debt is simply the debt interest level X 10. In other words, if your debt interest level for your student loan or mortgage is 3%, then allocate 30% of your savings to pay down your debt, and 70% of your savings towards investments.
FS-DAIR: Debt Interest Rate X 10 = Percent Of Savings Allocated Towards Debt Pay Down
If you have a debt interest level of 10% or higher, then you should consider allocating 100% of your savings to paying off that debt. The only debt interest levels above 10% in this current interest rate environment are debts from loan sharks and credit card companies. You might also be consolidating your debts via P2P borrowing on a place like Prosper at 10% or more. But at least it’s less than the alternatives. If this is the case, focus on paying down your P2P debt as well.
I strongly believe that using the FS-DAIR is an effective and easy guideline to use when facing the debt and investment dilemma. FS-DAIR is not perfect, but it is formulated in a way that seeks to maximize the efficient use of your capital over time.
Some of you might be asking what to do if you have multiple debts? The simple answer is to stick to the highest debt interest rate and adjust the ratio for paying down debt after the highest interest rate debt is paid off.
Paying Off Multiple Debt Strategy Example:
1) 16% interest credit card debt for $10,000
2) 9% interest P2P loan to consolidate your higher debts for $20,000.
3) 2.50% student loan debt for $10,000 over 20 years.
Using FS-DAIR, you would allocate 100% of every dollar saved beyond your comfortable liquidity level (3 months minimum is my recommendation) until the 16% credit card debt is paid down. Then you would allocate 90% of your savings towards paying down your P2P loan debt and 10% to invest. Once the P2P loan debt is paid off, then allocate 25% of each dollar saved towards paying off your student loans. Of course you are welcome to also pay down the smallest absolute dollar value debt as well to keep motivation alive. (Read: The Best Strategies To Get Out Of Debt And Be Happier In The Process)
Paying Off Student Loans And Investing In 401k Example:
1) 3% student loan debt of $25,000
2) 5% company match on salary of 401k contribution
3) $65,000 gross salary, $35,000 expenses
Here’s an interesting scenario brought up by a reader. He’s wondering how does FS-DAIR work if he cannot afford to max out his 401k to $18,000, but still wants to contribute and pay down debt. This is a tricky situation with no bad answers. My proposal is as follows:
1) Contribute at least 5% of gross salary to 401k to get 5% match e.g. contribute $3,250 and get another $3,250 for a total of $6,500. This way, no matter what happens he’s maximizing his returns.
2) Calculate net salary after contributing 5% e.g. $65,000 – $3,250 = $61,750 X 100-30% (effective tax rate) = $43,225.
3) Subtract net income of $43,225 to the realistic estimated expenses of $35,000 = $8,225.
4) Use 30% of $8,225 = $2,468 to pay down principal a year beyond the normal monthly payments.
5) Use 70% of $8,225 = $5,758 to invest in an equity index fund like SPY. He could and should just add $5,758 to his 401k contribution a year by contributing about $500 extra pre-tax to minimize his tax expenses. But at current income levels, he doesn’t have much in terms of a liquidity cushion, so it may be better to just invest $500 a month in an after tax instrument.
Note: Student loan interest is also generally deductible from your income too if your modified adjusted gross income (MAGI) is less than $75,000 ($155,000 if filing a joint return). The deduction can reduce the amount of your income subject to tax by up to $2,500 in. One day, the government will show equality for all.
Paying Off Mortgage Debt Example:
1) 5% 30-year fixed mortgage and no other debt
2) $100,000 gross income
You must calculate the real mortgage interest rate after deductions. If you are beyond the standard deduction levels and can’t figure out the exact deduction value, then a good estimate is to simply take your mortgage interest rate and multiply it by 100% minus your marginal tax rate, e.g. 5% mortgage X (100% – 33% marginal tax rate) = 3.35%. Use FS-DAIR again to allocate 33.5% of your savings to pay down your mortgage and 66.5% to invest. You can use the same framework above for contributing to a 401k.
If you have a $100,000 income or more, you should be able to max out your 401k. If not, continuously work your way up using FS-DAIR so that you do. And once you do max out your 401k, continue using FS-DAIR until all your debt is gone.
So what happens when you reach 0% debt because you don’t have any debt left? The answer is simple. Enjoy life, throw yourself a party, continue building passive income streams, and make sure your money doesn’t run out!
Wealth Building Recommendation
Manage Your Finances In One Place: One of the best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize your money. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances on an Excel spreadsheet. Now, I can just log into Personal Capital to see how all my accounts are doing, including my net worth. I can also see how much I’m spending and saving every month through their cash flow tool.
A great feature is their Portfolio Fee Analyzer, which runs your investment portfolio(s) through its software in a click of a button to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was hemorrhaging! There is no better financial tool online that has helped me more to achieve financial freedom. It only takes a minute to sign up.
Finally, they recently launched their amazing Retirement Planning Calculator that pulls in your real data and runs a Monte Carlo simulation to give you deep insights into your financial future. Personal Capital is free, and less than one minute to sign up. It’s one of the most valuable tools I’ve found to help achieve financial freedom.
Refinance Student Loans With SoFi: SoFi is a fantastic social lending company that provides rates as low as 1.9% variable with auto pay and 3.5% fixed with auto pay. The reason why they can offer lower rates than the rest is because they analyze you based on merit, quality of employment, and education besides just a credit score and financials. There is zero origination and prepayment fees. Offer terms are from 5, 10, 15, 20 years in both fixed and variable. Both private and public student loans can be refinanced.
Besides low rates, one of their best features is their unemployment benefits. If you lose your job while repaying your loans, you don’t have to pay your loan for up to 12 months while you look for a new job! Interest will still accrue, but having this cash flow break is a huge benefit. They also provide job assistance guidance as well. You can apply to refinance or apply for a new student loan here.
About the Author: Sam began investing his own money ever since he first opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 35 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond.