To Pay Off Loans Or To Max Out Your Company 401(K) - Invest Into The Stock Market?

That is the question.

It's crucial that you understand what decision to make if you're deciding between paying off loans and investing your hard earned money into the stock market.

The steps I take to answer this question are as follows (with the important disclaimers that this is not financial advice; this is simply how I think about this problem):

1. First determine your loan’s annual fixed interest rate. If you have an adjustable rate, this is a more complicated question to answer, in which case I would speak to your accountant/financial advisor. Please note, you may have access to a FREE financial advisor through your employer.

2. If your fixed interest rate is less than 5%, do NOT proceed to pay your loan down quickly. It's generally a better idea to invest into the US stock market.

3. If your fixed interest rate is greater than 5%, it’s generally not a bad idea to pay off your debt more quickly. However, I would still take advantage of employer matching contributions for your company 401(k) and Roth IRA.

It’s really as simple as that. Why this rationale and why this arbitrary 5%?

It's because when you’re paying off a loan, your return on investment is equal to the interest rate of the loan. A loan at 2% fixed interest rate is a 2% annual return on investment.

The US stock market returns, on average, 7% over long periods of time after adjusting for inflation. VTSAX is a low cost index fund that tracks the US stock market.

Why 5% and not 7%? This is because stock market returns on average are 7% per year but are not guaranteed. Paying down loans are guaranteed returns.

2% gives us some wiggle room, but you could be more aggressive and use 6% or 7% instead of 5%. Don’t take my word for it; Fidelity recommends 6% as a rule of thumb.

Let’s examine the actions of two people: Silly Sally and Wise Walt.

Silly Sally has a 30 year fixed interest rate loan on her home at a 2.5% interest rate.

Silly Sally hates debt, so she decides to spend an extra $15,000 per year paying off her home. She reduces her 401(k) contributions by $576 per paycheck ($15,000 per year) to do so.

Silly Sally also spends time clipping coupons, shopping around credit cards that have $100 signing bonuses, and shopping in the discount aisle.

Silly Sally feels like she has made a wise decision paying down her debt; she’ll have a paid off home much sooner now and she can relax debt-free at a younger age.

Was this mathematically the right decision? Absolutely not. I’ll explain this as we discuss Wise Walt’s financial situation.

Wise Walt also has a 30 year fixed interest rate loan on his home at a 2.5% interest rate.

Wise Walt understands that his company 401(k) is one of the best investment vehicles available and fully maximizes it out, increasing his contribution by $15,000 buying VTSAX, understanding it would be a foolish decision to pay down his home.

This is because Walt understands that if he pays off his 2.5% debt sooner, he is actually losing ~4.5% every year!

How is this the case?

Wise Walt’s 401(k) will do on average 7% per year if it’s entirely invested in a fund like VTSAX.

Wise Walt understands that if he pays down his debt faster, he is making a decision to earn 2.5% meaning those dollars can no longer earn 7% a year in his 401(k). 7%-2.5%=4.5%. Walt does not want to lose ~4.5% per year. Walt does NOT pay down his debt faster because he desires a differential +4.5% return on investment.

Wise Walt wastes no time clipping coupons, he doesn’t care much about credit card rewards, and spends every morning ordering avocado toast and overpriced mocha lattes from his local coffee shop.

All else equal, Wise Walt will be hundreds of thousands of dollars richer than Sally despite “throwing away” money and time living an enjoyable life.

Silly Sally, as you may guess, has wasted precious hours of her life clipping coupons  only to lose money by fumbling hard on bigger money decisions.

Sally is doubly foolish because she has also increased her taxable income by $15,000 per year. She normally pays taxes on $80,000 per year but will now pay taxes on $95,000 per year since she cut down her 401(k) contribution.

Sally did an excellent job at saving pennies and wasting her precious life energy and time (the only true non-renewable resource) clipping coupons only to shoot herself in the foot. Silly Sally proverbially threw wheelbarrows of cash directly into a campfire.

Mmmmmmm….marshmallows, yum.

Think twice before you pay off debt. Your high school and college counselors were not wrong; low-interest student debt, such as pharmacy school or medical school debt is good debt - for most people.

People that are willing to take on a bit more risk by NOT paying down low-interest, fixed rate debt, by instead putting those dollars into low cost index funds, are paid VERY handsomely over the long run. However, if you have an allergy to debt, maybe it’s the right way to go - FOR YOU.

Personally, I have zero qualms holding millions of dollars of low interest debt below 7%.

The grand irony is many who bemoan debt want to borrow money to buy real estate investment properties or start businesses - creating new debt - the same debt they were afraid of, but at even higher interest rates than student debt.

See the incongruence?

The rational borrower borrows as much as they can, as long as they can, at a low interest rate.

The foolish borrower borrows as much as they need, at a low interest rate, and pays it off quickly.

The most foolish borrower borrows as much as they can, as long as they can, at a high interest rate.

The rational borrower comes out the furthest ahead. As with most things in life, there’s no one best answer, but there are several wrong answers.