Summary: Should I Invest or Pay Down Debt?
As of 2017, the average university graduate in Canada had more than $26,000 in student debt.1 This is a situation where calculating the average is distorting: roughly 50% of Canadians graduate with no student debt at all. Clearly, the cost of education is a large burden for many grads. Student debt should ideally come with increased earning power, so when grads enter their earning years, should they be using their increased income to invest or pay down debt?
From a technical standpoint, the optimal approach is to invest money when the rate of return is higher than the interest rate that you pay on your debt. Like many technical responses to personal finance questions, this one is oversimplified and riddled with assumptions. Changes in the interest rate environment have further complicated matters, with the Canadian prime now sitting at 5.45%, significantly higher than the 2.45% that it was at only a few years ago. Most loans are quoted in relation to prime, so a hurdle rate of say, prime + 2% implies a return of nearly 7.5% in today’s rate environment versus less than 4.50% this time three years ago. Even with prime at these levels, the hurdle rate has still been achievable in recent years for the S&P 500:
| S&P 500 Returns by Year | |||||||||||
| Year | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | Average |
| Return | 7.11% | 16.00% | 32.39% | 13.69% | 1.38% | 11.96% | 21.83% | -4.38% | 31.49% | 5.95% | 13.24% |
Excluding recency bias for 2022, the last 10 years have been great for equity investors, but even a period that returned 12.52% per year demonstrated wild volatility. Annual data is also covering up huge intra-year swings. Based on this data, 2020 looks like a nice, steady growth year. What the annual return isn’t showing is a 34% drawdown and subsequent rebound to all-time highs.
This data highlights a critical issue with constructing an investment portfolio: sequence of returns risk. Given long enough time horizons, equity markets have demonstrated the highest rates of return among asset classes. But with higher average returns comes greater volatility year to year. If you need to access funds next year, higher long-run average returns won’t help you if your portfolio just experienced a significant drawdown. Therein lies the flaw with investing excess cash flow rather than paying down debt: if the repayment terms on your debt aren’t sufficiently long, you may not be able to capitalize on the excess of investment returns over the interest rate paid on debt.
By my estimation, the decision to invest excess cash or use it to pay down debt comes down to two main variables:
1. The type of debt you are carrying.
Some forms of debt are implicitly encouraged. Student loans are the most common example. The government believes that a well-educated population is a good thing, and to further incentivize higher education they have made the interest on student loans tax deductible. This reduces the cost of carrying student loan debt. Your rate of return on paying down the student loan debt is guaranteed and it’s the interest that you avoid having to pay in the future. Given the (usually) low rates on student loans and the tax deductibility of the loan interest, you may prefer to invest excess cash flow rather than accelerating your loan payments.
Mortgages, secured loans used to purchase homes, represent the lion’s share of total debt volume. The majority of the net worth of most Canadians is tied up in their primary residence. Since your home will already be your biggest asset, investing in something besides your own house’s equity will serve as a form of diversification. However, mortgage rates have skyrocketed alongside the prime rate, making the appeal of investing excess cash flow rather than paying down your mortgage more quickly less attractive. But just as mortgage rates have gone up, valuations in the stock market have fallen, and long-run return prospects have improved. Real estate prices have also started to fall, so while paying down your mortgage more quickly allows you to build equity in your home, in this instance you are increasing your equity stake in a depreciating asset.
Investing excess cash rather than paying down your mortgage more quickly is an even more intriguing opportunity in the United States, where mortgage interest is tax-deductible (click here to read how you can do that with your mortgage in Canada by using the “Smith Maneuver”).
2. The psychological effects of debt.
Some individuals happily use debt to take advantage of the leverage it provides (this is the cornerstone of private equity investing). But even if a debtor position may theoretically be optimal in certain situations, you still have to be able to sleep at night. If paying down debt will ease your psychological burden, then you can worry about putting money to work in the markets once your debt obligations are under control.
No matter what you choose to do, it’s important to keep in mind that both investing and paying down debt are smart investment choices. Applaud yourself for deciding between these alternatives rather than using your excess cash on discretionary purchases.
1 Stats Canada only refreshes this data every 5 years
Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.
