The landscape · Behavior
High interest debt and the arithmetic of paying it versus investing
A dollar used to pay down a debt earns a return equal to the debt's interest rate, with no tax and no uncertainty, which is the figure any alternative use of that dollar is compared against.
Who this exists for. This applies when a person carries a balance at a high interest rate while also having money that could be saved or invested. Ticks that show it: I carry debt above a few percent; I work for an employer; I am under 50.
How it works
Interest on a credit card at 24 percent means every $100 of balance costs $24 a year, so paying off $100 saves $24 a year with certainty. The long run return on a broad stock fund has averaged in the range of 7 to 10 percent a year before tax, with large swings. Interest on consumer debt is not deductible, and investment returns in a taxable account are taxed. Debt at a rate above what investments are likely to earn costs more each year than the investment would make, while debt at a low rate, such as a mortgage at 3 percent, is the opposite. The one exception many people carve out is an employer match, which returns 50 to 100 percent at once.
What it gives
Paying a 24 percent debt is a certain 24 percent return, which no investment offers.
The saving shows up in the next month's statement, with no waiting.
Interest avoided is never taxed, unlike interest or gains earned.
What it costs, or where the catch is
Money sent to debt is gone from reach, while a cushion or an investment can be tapped.
A debt at a low fixed rate can cost less than the long run return on investments, so the arithmetic runs the other way.
Paying debt first can mean missing a year of an employer match that cannot be made up later.
A worked example
Sol has a $6,000 card balance at 24 percent and $500 a month to use. Sending it to the card clears the balance in about 14 months and costs roughly $930 in interest along the way. Investing the same $500 a month at 8 percent for 14 months would have earned about $320 before tax. Carrying the card while investing would have cost far more in interest than the investing earned. She keeps taking her 401(k) match throughout, since that is a 50 percent return at once.
Where it goes wrong
The common miss is investing while carrying a card balance for years, which earns a hoped for 8 percent while paying a certain 24.
Who confirms it for you
Nobody has to; it is arithmetic you can check yourself with the numbers above.
The official source
USA.gov: Dealing with debt. Every figure that changes by year comes from the site's rules table, which the watcher checks against the official page on a schedule; where a figure is not yet verified, this page says so instead of printing a number.
Ask about High interest debt and the arithmetic of paying it versus investing
A model reads this page and answers from it. It will say when the answer is not on the page. Education, not personalized advice.
Nearby doors
- The employer match
This exists for anyone whose job offers a retirement plan with matching contributions.
- Traditional 401(k) contributions from pay
This exists for anyone whose employer offers a 401(k) plan and who wants to know what happens when part of a paycheck goes into it.
- The Roth 401(k) option inside the plan
This exists for a worker whose 401(k), 403(b), or 457(b) plan offers a designated Roth account alongside the traditional one.
- The 403(b) for schools and nonprofits
This exists for people who work at public schools, colleges, hospitals, churches, and other nonprofit employers that offer a 403(b) plan.
- The 457(b) and its separate limit
This exists for state and local government workers and some nonprofit employees whose employer offers a 457(b) deferred compensation plan.
- Vesting schedules
This applies when an employer puts money into a worker's retirement plan and the plan document says that money becomes the worker's over time.
Education, not advice. Wealthy Habitat explains how rules work and never recommends what to do with your money. The No Advice Disclosure.