Summary: 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 theyou pay on your debt. Like many technical responses to personal finance questions, this one is oversimplified and riddled with assumptions. With the exception of rates charged on credit cards and by predatory lenders, it is safe to assume that the long-run returns on a diversified investment portfolio should exceed the interest assessed on most loans. The emphasis here is on long-run returns. When looking at returns in the stock market, the average doesn’t tell the whole story. Here are the returns for the S&P 500 for the last 10 years:
Without question, the last 10 years have been great for equity investors, but even a period that returned 13.24% 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 and 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.
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. Historically low mortgage rates also present a good opportunity to put excess cash into the markets instead of applying it to your mortgage.
2. The psychological effects of debt.
Some individuals happily take on 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 blowing 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.