DISCLAIMER: This chapter references general topics like deductible debt, but nothing included should be interpreted as tax advice. You should see a tax adviser if considering these topics.

Deciding whether to pay off debt or invest can be hard. Obviously, both are important, but how do you decide between the two when money is in short supply?

Debt can be a sensitive and stressful topic for most people. The feeling of being saddled with debt can range on a spectrum, ranging from mild uneasiness to soul-crushing despondence. It’s no surprise that we feel that way. Most of us are taught that debt is ‘bad, shameful, and morally wrong’, despite how common it is. But it’s not the end of the world. Debt happens, and it’s reasonable to want to get rid of it quickly.

While the compulsion to get back into the black is quite reasonable, what you should do with your money is a bit complicated. In some situations, it may be smarter to let your debt sit tight for a while, and invest the cash instead.

In others, it makes sense to pay off your debt ASAP – and this is almost always the case if you have bad debt. The interest charged on personal loans, credit cards or overdue buy now, pay later loans is far more than the return you can reliably expect from any investment – and that’s before tax!

So if you take nothing else from this chapter, know that you should always pay off bad debt before you invest.

Before you can make a decision about whether to pay off your debt or invest, you'll need some important information! Specifically:

• The case for paying debt off first
• Types of debt
• So what type of debt do I pay off first?
• Common debt reduction strategies
• What about paying off the loan on my home?
• Benefits to investing sooner rather than later
• Can you pay off debt and invest at the same time?
• Doing a cost-benefit analysis
• Working backwards
• The element of uncertainty
• A very personal decision

The case for paying debt off first

Debt can be a terrible burden on your finances. It can be frustrating to have to commit a portion of your income to repaying debt, leaving less to cover your living expenses.

There are some good reasons to consider eliminating debt before starting your investing journey:

1. Less debt means less interest paid to the bank
2. Getting rid of the debt will free up more cash to save and invest
3. Being #debtfree is a major achievement, which gives you a clean slate to begin your FIRE journey
4. Can be an easy target to achieve, particularly if the debt amount is not high

Let’s say you have a personal loan of $10,000 at 15% interest. If you pay the minimum repayment amount of $300 a month towards the loan, you’d fully pay off the loan in 4 years. The total interest you’d pay over that time will amount to $3,017.

If you doubled your repayments, you’d clear the loan in 2 years, saving you $1,733 in interest.

What’s more, by clearing your debt first, you’re effectively guaranteeing yourself a return on investment equal to the debt interest rate. In the example above, your return on investment would be 15% (after-tax!).

Types of debt

Debts come in all shapes and sizes. In the previous chapter, we explained the difference between good debt and bad debt.

Now let’s look at an alternative view of debt - deductible debt, and non-deductible debt.

Deductible debt

Deductible debt is debt used to purchase assets that will generate an income. The Australian Tax Office (ATO) allows you to claim the cost of this debt as a tax deduction. Some examples of income-producing assets are investment property, shares, and managed funds.

In general, deductible debt is used to purchase ‘good debt’. A loan against an investment property is considered deductible debt because the investment property can return a rental income. A margin loan to purchase shares or managed funds is also deductible provided that they may return an income via dividends or capital gains.

Unfortunately, a loan to purchase a principal place of residence (PPOR), which is the home you live in, is not deductible. That’s because you don’t receive an income from your home. However, if you rent out part of your home and receive rental income, a proportion of your home loan may become tax-deductible.

Non-deductible debt

Conversely, non-deductible debt is debt that cannot be claimed as a tax deduction. The ATO classifies this debt as ‘personal use’ i.e. debt that does not return an income. For example, interest incurred on a personal loan for a holiday or a new car is not tax-deductible. Nor is interest on a credit card used for your everyday spending.

Most ‘bad debt’ is not tax-deductible as they’re often used for non-income producing purposes.

However, if you used a personal loan to purchase shares, it would be deductible. That’s because you’ll be earning an income from the shares. But with interest rates on personal loans far exceeding the return on shares, it may make more sense to use a different type of loan for the purchase instead!

So what type of debt do I pay off first?

Most financial advisors recommend that you pay off non-deductible debt first. That’s because non-deductible debt will not give you any tax benefits. Plus, most non-deductible debts tend to depreciate in value - cars, holidays, and the like.

Ideally, you’d start with the ones with the highest interest rates. Most bad debt, like personal loans or credit cards, has much higher interest rates than good debt. At the time of writing the interest on personal loans and credit cards start from 8.99% upwards.

Based on just the interest rate alone, it makes good financial sense to clear bad debt with high-interest rates as quickly as possible before starting on your investment journey.

Common debt reduction strategies

Debt stacking

This method of debt reduction involves listing your debts from the highest interest rate to the lowest interest rate. You then put as much money as you can towards the debt with the highest interest. Once that’s paid, you move to the next highest. So on and so forth until all debts are paid.

The stacking method makes the most financial sense. By tackling the loan with the highest interest rate first, you will end up paying less in interest. Minimising the amount of interest you pay is a big win, as it allows you to spend as little as possible to get back on track.

Snowball

With the snowball method, you’d pay off your loans from smallest to largest. The strength of this method is in its ability to let you feel you’re conquering your debt mountain one step at a time. Each time you cross a debt off your list, you’ll get a huge psychological boost. This, in turn, gives you more confidence in your financial management skills - always handy to have when you’re on this FIRE journey.

However, the snowball method may not be the most cost-efficient as debt stacking; particularly if the largest loans are also the ones with the highest interest rate.

What about paying off the loan on my home?

Home loan rates tend to sit around 3-5%. But as we’ve discussed before, they’re not tax-deductible. Though conventional wisdom tells us non-deductible debt should be paid first, some different considerations apply in this case.

Due to the high cost of housing in Australia, loans for property run in the hundreds of thousands of dollars. The average Australian will be paying their home loan over 20-30 years. It can feel like a long, hard slog - and when it’s finally paid off, who knows how far the market might have moved in that time. Property also typically appreciates in value over time, which is another point of difference compared to other non-deductible assets.

The question then becomes - is it still worth paying your home loan off, if it means starting the investment journey later?

Benefits to investing sooner rather than later

“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn't, pays it.” - Albert Einstein

The biggest benefit of investing sooner is simple: the power of compounding.

The compounding effect

Compound interest is simply interest paid on interest. When you invest money, you get a return on your principal over a period of time. Over time, this includes all of the accumulated interest from all previous periods. This compounding effect will make a sum grow at a much faster rate than simple interest, which is calculated only on the initial principal.

The compounding effect is particularly noticeable over long periods of time. In short, the earlier you start investing, the bigger your returns.

Assume you have $300 to invest each month. Your investments earn 7% interest per year. The table below shows how much your investment would have compounded if you had stayed invested over 20 years.

At the end of 10 years, the interest earned is just under half of what you invested. But at the end of year 20, the interest earned is more than what you personally put in. Such is the power of compounding. This alone is why you should consider investing early, and often.If you had waited to clear your debt first, you would have missed out on the power of compounding. Using the example above, if it took 5 years to clear your debt before investing, your final balance would have been $95,643.57. That’s a reduction of about $61,546.25 just from delaying your investment by a mere five years.

Can you pay off debt and invest at the same time?

Suppose you have some extra money, and you’re trying to decide whether you should invest it or pay down your debt. We’ll explain how to run a cost-benefit analysis that can help point you in the right direction.

Understanding the after-tax rate of return

The after-tax rate of return is the return on an investment after subtracting the effects of taxes. Almost all investments state their rate of return before tax. We need the after-tax rate of return because it is a more accurate measure of performance after the ATO has taken their share. The after-tax rate of return takes into account your personal marginal tax rate, so it’s handy to know this number. The ATO publishes a table that sets out individual income tax rates. You could also use the Money Smart calculator.

Doing a cost-benefit analysis

Theoretically, the smartest thing to do is to compare two numbers:1. The interest rate you are paying on your debt2. The after-tax rate of return you expect from your investmentGenerally, if the after-tax rate of return is higher than your debt’s interest rate, then it would make more sense to invest than paying off the loan.The formula for calculating your after-tax rate of return is:After-tax rate of return = Pre-tax rate of return x (1 - tax rate)Time for another example: Let’s say you’re on the 37% marginal tax rate. You have a choice of paying down your home loan at 3%, or making an investment that will return 7% (before tax) annually.If you decided to invest, you would get an after-tax return of 4.41%. This is calculated as follows:0.07 x (1 - 0.37) = 0.0441 or 4.41%.Since the after-tax rate of return (4.41%) is higher than your current debt interest rate (3%), you would be better off using the extra funds to invest, rather than pay down your loan.

Such is the power of compounding. This alone is why you should consider investing early, and often.

If you had waited to clear your debt first, you would have missed out on the power of compounding. Using the example above, if it took 5 years to clear your debt before investing, your final balance would have been $95,643.57. That’s a reduction of about $61,546.25 just from delaying your investment by a mere five years.

Can you pay off debt and invest at the same time?

Suppose you have some extra money, and you’re trying to decide whether you should invest it or pay down your debt. We’ll explain how to run a cost-benefit analysis that can help point you in the right direction.

Understanding the after-tax rate of return

The after-tax rate of return is the return on an investment after subtracting the effects of taxes.

Almost all investments state their rate of return before tax. We need the after-tax rate of return because it is a more accurate measure of performance after the ATO has taken their share.

The after-tax rate of return takes into account your personal marginal tax rate, so it’s handy to know this number. The ATO publishes a table that sets out Compound interest.

https://www.ato.gov.au/rates/individual-income-tax-rates

You could also use the Money Smart calculator to help you work out your tax rate:

https://moneysmart.gov.au/income-tax/income-tax-calculator

Doing a cost-benefit analysis

Theoretically, the smartest thing to do is to compare two numbers:

1. The interest rate you are paying on your debt
2. The after-tax rate of return you expect from your investment

Generally, if the after-tax rate of return is higher than your debt’s interest rate, then it would make more sense to invest than paying off the loan.

The formula for calculating your after-tax rate of return is:

After-tax rate of return = Pre-tax rate of return x (1 - tax rate)

Time for another example: Let’s say you’re on the 37% marginal tax rate. You have a choice of paying down your home loan at 3%, or making an investment that will return 7% (before tax) annually.

If you decided to invest, you would get an after-tax return of 4.41%. This is calculated as follows:

0.07 x (1 - 0.37) = 0.0441 or 4.41%.

Since the after-tax rate of return (4.41%) is higher than your current debt interest rate (3%), you would be better off using the extra funds to invest, rather than pay down your loan.

The chart above shows the relationship between the after-tax rate of return against all the different Australian marginal tax rates. In general, if you’re on the lower tax brackets, you’ll get a larger after-tax benefit if you invest compared to those on higher tax brackets.

Now you know why accountants typically advise that investments should be made in the name of the lower-income earner (but definitely speak to your accountant to get specific advice for your situation)!

If that’s all too complicated, don’t fret. Here’s a handy debt calculator to help you work it out. Simply plug in the interest rate on your debt, your expected return on investment, and your marginal tax rate.

Working backwards

Calculating minimum rate of return required for non-deductible debt

You can also use the same formula to work out the minimum rate of return (pre-tax) that you would need to make investing worthwhile. Simply flip the formula around like so:

Pre-tax rate of return = After-tax rate of return / (1 - tax rate)

Using the same example as before, your current after-tax rate of return is simply the interest rate for your home loan (3%). This is because your home loan is not deductible and you’re paying it with after-tax dollars.

So the minimum return on investment you would need is:

0.03 / (1 - 0.37) = 0.0476 or 4.76%

In this case, any investment you make will need to be returning at least 4.76% before tax. Anything lower isn’t worth considering; you will do much better using excess funds to pay down your existing debt.

Comparing deductible debt against potential investment

Note that the examples above assume you have non-deductible debt. As explained earlier, non-deductible debt is when the debt is personal in nature and does not qualify for a tax deduction.

Comparing deductible debt against a potential investment is much simpler, and does not require any calculation. This is because the interest on your debt is already tax-deductible, paid with pre-tax dollars - and is therefore equal to your pre-tax rate of return.

So if you had an existing investment loan of 3% and wanted to invest in a different asset, you would need to find another investment returning greater than 3% to make it worthwhile.

It’s that easy!

There’s also an advanced strategy called debt recycling, where you can turn non-deductible debt (such as your home loan) into deductible debt. We’ll cover this in a bit more detail in Chapter 19 - Fuel for the FIRE - Leverage.

The element of uncertainty

Whilst we’ve covered the logical side of things, there’s an element we cannot discount: Our emotions.

Risk tolerance

Behavioural economics go into a lot of depth on the relationship between human behaviour and risk tolerance.

When people are exposed to uncertainty, they exhibit one of two behaviours. Risk seekers are willing to take a punt on an uncertain outcome. Those who are risk-averse prefer to take on a sure shot.

Your risk tolerance can be a factor in your decision to pay off your loan or invest.

There is no guarantee that if you invest, you’ll get that magical 7% returns. Past performance is not an indicator of future performance. Even if the data shows us that over the long term, 7% return in a well-diversified balanced portfolio is possible, it may or may not turn out the case in the future.

So what will you choose when faced between paying off your loan (which is a known quantity, and largely under your control), and the possibility of a higher investment return?

Some people just feel more comfortable taking the safe option. They might prefer being debt-free. They don’t want the additional burden of debt over their head. And that’s perfectly okay! If your debt is affecting your peace of mind, then perhaps you might prioritise getting rid of the debt completely.

If you’re generally risk-averse, you shouldn’t feel obligated to weigh any factor in this decision any more than what makes you sleep better at night. After all, you need to be able to live with your decision. Don’t be afraid to prioritise paying debt off even if the numbers are in favour of investing. This could be one of those rare situations where money can buy happiness.

But if you find yourself being ambivalent about both options, then run the numbers, and see what comes up. The answer may very well lie in the math.

A very personal decision

Ultimately the decision boils down to a simple variable - you. Your decision has to factor in three things:

1. What’s important to you
2. How likely you are to stick with that decision
3. What lets you sleep well at night

No matter which path you choose, you should eventually get to the end-game, which is to have zero debt, and an abundance of quality investments that give you the means to retire early. With some effort and a bit of patience, FIRE is a goal that you can achieve.

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About Ms FireMum from A Family on FIRE | afamilyonfire.com

Hi, I’m Ms FireMum. My husband and I are seasoned investors, having started our investing journey early in life, but we’ve only recently discovered FIRE! So we’re now on a mission to turbocharge our nest egg and achieve financial independence by our mid-40s. I write about our journey at A Family on FIRE – with stories on being frugal, saving, and investing - all while bringing kids along for the ride!

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