Finance, Investing

Should You Pay Off All Your Debt?

investment hurdle rate, saving, investing, paying off debt, debt, personal finance

The desire to be debt-free is strong in the FIRE community and for people in general. Does it always make sense to pay off all your debt, though?

Imaginary Scenario

Let’s say I give you $100.

Do you use that money to pay off debt, do you augment your emergency funds, or do you invest it?

The answer isn’t always easy.

Generally speaking, if you don’t have your emergency fund fully funded (I recommend 6 months to 1 year of monthly expenses), any excess money should go there.

What if your emergency fund is good to go?

There’s a simple metric I like ot use to decide whether or not I will pay off debt or invest it instead.

Discount Rate

In the financial industry, it’s often part of our job to value a company or business. This could be to make an investment in a fund, or it could be to act as an intermediary in the sale of a company (investment bankers).

A crucial metric that we use is the discount rate of a company.

Discount rates are primarily used in Discounted Cash Flow valuations. I could go on for days about DCFs but I’ll stop here.

A theory in finance stipulates that a dollar today is worth more than a dollar tomorrow. Discount rates are used to calculate the value of future dollars in today’s dollars. They discount the worth of a dollar in, let’s say, five years versus what it’s worth today.

It’s All About Opportunity Cost

Going back to our imaginery scenario, what do you do with that hundred bucks if you’ve already topped-off your emergency fund? How do you quantify if the money is best used to pay off debt or invest?

You have to quantify the opportunity cost associated with that money. If your debt has a 1% interest rate but you have a lot of certainty around getting a 5% return in the stock market, it makes more sense to invest.

The net effect of the investment and your existing debt together result in a positive return. You make more money long-term by investing.

However, if you have a 20% interest rate on your debt and you expect a 10% return in the stock market, you’d be crazy to invest instead of paying-off that high-interest debt.

This expected return is your opportunity cost. As long as it’s greater than your debt’s interest rate, you invest.

Investment Hurdle Rate

I’ve customized the discount rate formula for use in our personal finances!

I call it the Investment Hurdle Rate (“IHR”).

To calculate it, take the current risk-free (“Rf”) rate and add it to the equity risk premium (“ERP”).

IHR = Rf + ERP

The risk-free rate is typically the yield on 10-year U.S. treasuries.

The equity risk premium is the excess return that investing in stocks provides versus investing in 10-year treasuries. The ERP is implied using current stock market index data (in this case, the S&P 500).

While you can find this data yourself online, I’ve made it easy and always have the Investment Hurdle Rate featured in the right sidebar of this site. I’ll update this on a monthly basis!

The current IHR (January 2018) is:

Rf (2.62%) + ERP (4.75%) = IHR (7.37%)

Back to Imaginery Scenario

If any of your existing debt has an interest rate over 7.37%, use the $100 to help pay it off! If it has rate lower than that, consider investing it instead.

I wrote a post several months ago about calculating your cost of debt.

While it’s more complicated than simply splicing out all your individual debt rates and picking off any that are over the IHR, I recommend knowing your cost of debt so you can quickly make investment decisions.

Conclusion

Personal finance is, well, personal. If you absolutely hate the idea of having ANY debt, even if it has a low interest rate, pay off all your debt first before you invest more than the minimum needed to get your company’s 401(k) match.

However, the IHR is a great metric to quickly sort out which debt is mathematically worth it to pay off first and what can wait.

Will you use the Investment Hurdle Rate to guide your investment decisions? Do you have any debt with a higher interest rate than the IHR? Comment below!

 

 

 

Tagged , , , , , , ,

5 thoughts on “Should You Pay Off All Your Debt?

  1. Great post. I’ve just started a pay off debt or invest series on my site. I’ve been looking for a way to pinpoint an exact rate on debt that one makes more sense than the other and you’ve done it.

    Does the ERP you use somehow factor in current valuations? I’ve heard John Bogle predict 4% real returns going forward so the 7% figure you provided seems high based on that.

    1. Thanks, Jason! Glad you find this useful.

      Great question. First, Bogle mentions real returns, ie returns net of inflation. The IHR does not take into account inflation or deflation. If you take out the effect of inflation (actual consumer inflation including cost of gas etc.) I’m sure the number is closer to 4%. ERPs also have little correlation to inflation.

      The implied ERP (what I use here) uses estimated future dividends and buybacks (estimated stock cash flows) to calculate the Required Return on Equity. ERP is ROE minus the risk-free rate. By adding back in the risk-free rate, I’ve effectively reconstructed the Required Return on Equity. For the discount rate on an individual stock, that stocks beta is taken into account. Given that we are using the S&P 500 here and you’re benchmarking to itself, the beta is 1 so it doesn’t impact the equation.

      Hope this makes sense, let me know if it doesn’t!

  2. To be clearer, the IHR does take current valuations into account, albeit indirectly. Buybacks and dividends correlate somewhat with valuations but expected cash flows drive the figure.

  3. I like your acronym IHR – the investment hurdle rate. That is a good way to think of it. And I’m all about leverage when it makes sense!

Leave a reply or ask a question