The decision to pay down debt or invest is a personal one. It depends on a lot of factors such as 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 whether to pay down debt or invest over the years. As a result, I came up with the Financial Samurai Debt And Investment Ratio, or FS DAIR for short back in 2014. Despite interest rates plunging since then, the FS DAIR framework still holds up strong.
The FS DAIR formula for deciding whether to pay down debt or invest is as follows:
Debt interest rate X 10 = percent of cash flow after living expenses allocated towards debt pay down
In other words, if you have a mortgage with an interest rate of 3%, utilize 30% of your monthly cash flow after living expenses each paycheck to pay down debt. Invest the remaining 70% of your cash flow based on your investment preferences.
If you concurrently pay down debt and invest, it’s very hard to lose in the long run. Ultimately, it’s best to be debt-free when you retiree or no longer have the desire to work.
As the CFO of our own finances, it’s up to us to figure out the most efficient use of capital. With FS DAIR, you will approach paying down debt or investing in a rational manner.
Basic Background Of Interest Rates And Returns
When deciding on whether to pay down debt or invest, it’s good to get some fundamental background on interest rates and risk asset returns.
Stocks have historically returned as little as 1% in the 2000s to as high as 19.58% in the 1950s. The average stock market return since 1926 is roughly 10%.
We also know that the 10-year yield has come down from 14.5% in the mid 1980s to around 1% 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. We’re talking 17-19% in the 1970s to still around 10%-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. You also want to improve your financial security by paying down debt and raising cash.
Given interest rates are so low now, there is a tendency for investors to chase yield. The risk is that investors allocate too high a percentage of their capital to risk assets at historically high valuations.
Lack of discipline can result in financial catastrophe. With FS DAIR, an investor with leverage always rationally allocates new capital. Use FS DAIR to decide whether to pay down debt or invest.
Everything Is Yin Yang In Finance
Finance is Yin Yang. Nothing happens in a vacuum. If income growth, the stock market, and inflation all start going ballistic, the Fed will raise interest rates more aggressively to contain inflation. With higher borrowing costs, stocks may fall and income growth may fade. As a result, inflation may come down.
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, the housing market crashed in 2008-2009, and the economy tanked in 1H2020 due to the global pandemic.
Unfortunately, the Fed’s actions can also create asset bubbles, which often end in tears. Using monetary policy to tweak the economy is not easy, but we’re getting more efficient at it.
Interest Rates Tell Us A Lot
You can view interest rates as a reflection of inflation. Tell me the interest rate on a savings account in any country and I can tell you the country’s nominal interest rate within a couple percent.
For example, a while back, a couple readers commented they were earning an 8-9% savings account interest rate in India. That’s an incredible return since the average US savings interest rate at the time was only around 0.25%.
The reason why Indian savings accounts were returning 9% a year was because nominal inflation in India was running at least 8% a year! The real interest rate was, therefore, only 1%. 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. Everything is always relative in finance.
Property Buying During A Low-Interest Rate Environment
Real estate in America is hot partly because mortgage rates have come down. I believe the best time to buy property is when you can afford to do so mainly due to inflation.
Given the average property value is multiples higher than the average income, property will eventually become unaffordable for more and more people due to inflation.
For example, if a $1 million dollar property increases by 3% a year and your $100,000 a year income also increases by 3% a year, you are actually falling behind by $27,000 a year!
You have to increase your income by 30% a year just to keep up! The alternative way a potential homebuyer can benefit is when mortgage rates decline. However, hope is not a great wealth-building strategy.
If you can’t afford to buy your primary residence, then at least gain exposure to real estate through REITs and real estate crowdfunding investments around the country.
I personally invested $810,000 in real estate crowdfunding in 2016 and 2017. My investments mostly are in heartland real estate where valuations are cheaper and rental yields are much higher.
What To Do When Interest Rates Increase?
If you believe interest rates will be rising, then your existing debt becomes “more valuable.” When your debt becomes more valuable, you should therefore, hold onto your debt for longer.
For example, let’s say you are borrowing at 3%, but comparable loans rise to 10% in three years. The value of your debt increases because other people would be willing to pay you more for the ability to borrow at 7% lower interest rates. Your debt is more valuable because it is relatively cheaper to fund.
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 invest in equities, real estate, REITs, private equity, and more 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%. Two percent-yielding stocks start looking more appealing now. Therefore, incremental capital will likely flow towards stocks.
In fact, common practice is to allocate more to equities whenever the S&P 500 dividend yield is greater than the 10-year bond yield. This is one of my favorite bullish indicators for stocks.
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, let’s look at FS DAIR in more detail.
I truly believe FS DAIR is the most logical way to decide how much you should allocate towards paying down debt or investing. FS DAIR smartly helps you allocate capital based on the environment.
Once again, the percentage of one dollar you should consider allocating to paying down debt is the debt interest rate X 10. In other words, if your debt interest level for your student loan is 5%, then allocate 50% of your savings to pay down your debt and 50% of your savings towards investing.
There is one important point about FS DAIR that should also be followed. If you have a debt interest rate of 10% or higher, then you should consider allocating 100% of your savings to paying off that debt. I use 10% because it’s easy to remember and it’s the average return for stocks since 1926.
The only debt interest levels above 10% in this current interest rate environment are debts from credit card companies, pay day loans, and loan sharks.
You might also be consolidating your debts by getting a personal loan through a lending marketplace like Credible. You should be able to get a personal loan interest rate that is much is lower than the average credit card interest rate.
Below is my FS-DAIR guide to help you decide whether to pay down debt or invest.
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 focus on paying down your highest interest rate debt first using FS DAIR.
Paying Down Three Types Of Debt Using FS DAIR
Let’s say you find yourself with the following types of debt:
1) 16% interest credit card debt for $10,000
2) 9% interest on a personal loan
3) 3% 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 (6 months minimum is my recommendation) until the 16% credit card debt is paid off. 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 30% of each dollar saved towards paying off your student loans. The remaining 70% of your savings can be used to invest. Of course you are welcome to also pay down the smallest absolute dollar value debt as well to keep motivation alive.
Paying Off A Student Loan And Investing In A 401(k)
Now let’s take a look at a common situation where a recent college graduate would like to invest in her 401(k) and pay down student loan debt.
1) 3% student loan debt of $25,000
2) 100% 401(k) company match up to $3,000
Allocate 30% of savings to paying down extra student loan debt each pay check. At minimum, contribute at least $3,000 in one year to get the full $3,000 match for an automatic 100% annual return.
Depending on disposable income, the ideal situation is to contribute the maximum possible to a 401(k) ($19,500 for 2021). This way, after 30+ years of contributing, you will likely have at least $1 million in your 401(k).
With any money left over, aggressively build a taxable investment portfolio in order to generate useable passive income.
Paying Off Mortgage Debt Example
Finally, here’s another common example of deciding whether to pay down mortgage principal or invest.
1) 4% 30-year fixed mortgage and no other debt
2) $100,000 gross income
It’s good to 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.
In this case, 4% mortgage X (100% – 32% marginal tax rate) = 2.72%.
Use FS DAIR again to allocate between 27% to 40% of your savings towards paying down mortgage principal. The remaining 60% – 73% should be invested after paying for general living expenses.
Although it may feel off to pay down such cheap mortgage debt, your goal is to remain disciplined in following the FS DAIR framework. You never know how your risk assets will perform. If your risk assets perform poorly, at least you’ll feel great knowing that you paid off some debt.
Of course, if you have a 4% 30-year fixed rate mortgage, a no-brainer move today would be to refinance your mortgage to <3%. I would check the latest mortgage rates with Credible, my favorite mortgage lender. Qualified lenders will provide real, no-obligation quotes in minutes.
Lowering your mortgage rate and then continuing to pay down extra principal is a power move.
When You Have No More Debt
So what happens when you no longer have any debt to pay off? The answer is simple. Enjoy life, throw yourself a party, continue building passive income streams, and make sure your money doesn’t run out!
Paying down debt is a great feeling. I’ve never regretted paying off a mortgage in my 20+ years of owning property. Paying off my $40,000 business school loan with a 3.5% interest rate in 2008 also felt great too because the stock market imploded soon after.
However, making money in stocks, real estate, and other risk assets is what will make us richer over time.
If low interest rates are too tempting to ignore, make sure the debt payments are affordable. I’ve got the 30/30/3 rule for home buying and the 1/10th rule for car buying to cover the majority of purchases using debt.
I never recommend anyone carry revolving credit card debt unless there’s just no other way. Credit card interest rates are simply way too high.
Boom times are here again in the stock market and real estate market thanks to an accommodative Fed, effective vaccines, a rebound in corporate earnings, and a recovery in job growth. Just make sure to stay disciplined if you have debt.
If you find yourself asking yourself whether to pay down debt or invest, I say always do both. This way, you’ll guarantee to always do at least one thing right!
Readers, do you have a pay down debt or invest framework? In such a low interest rate environment, how much extra debt are you paying down each month if at all?