Expensive debt first
As long as you have high-interest debt, paying it down is the best investment available. It offers a guaranteed, tax-free return equal to the loan's interest rate.
Anyone paying 12 percent interest on an overdraft while hoping to earn 7 percent in stocks loses money every year, no matter how well the stocks perform.
Every euro you put toward an expensive loan saves you its interest. That saving is guaranteed. It doesn't depend on any market and isn't taxed. You won't find that anywhere else.
A rough rule of thumb: pay down anything above roughly five percent interest first. Below that, say an old mortgage with a low rate, investing alongside it can make sense.
If you have several debts, there are two approaches. The mathematically best one is to pay off the highest interest rate first. The one that's often better for your head is to clear the smallest debt first, because finishing off that first loan is motivating. Either approach beats doing neither.
Formally, paying down debt is an investment with a return equal to the effective interest rate and zero risk. That return is also tax-free, since interest you avoid paying isn't income. An investment therefore has to earn considerably more before tax just to match it. With a flat tax including surcharges of around 26 percent, an 8 percent loan rate corresponds to a required gross return of about 10.8 percent.
The stated five-percent threshold isn't a law of nature, it follows from comparing against a plausible expected after-tax return of a broadly diversified stock portfolio. As interest rates rise, the threshold shifts upward; as they fall, downward. To calculate it properly, compare your loan's effective rate to your own expected after-tax return, and remember the latter is uncertain and deserves a discount for that.
On the order for multiple debts: paying down by descending interest rate minimizes total interest cost and is mathematically optimal. Paying down by ascending remaining balance closes accounts faster and, in behavioral-economics studies, gets followed through more often. The difference in total cost, in typical situations, is smaller than the difference between sticking with a plan and abandoning it.
Summary
- Paying down debt is a guaranteed, tax-free return equal to the loan's interest rate.
- Above roughly five percent interest: pay down first, then invest.
- The path you actually stick with beats the mathematically optimal one.
Did you get it?
Why can't a debt payoff's return be compared directly to an investment return?
Because it's guaranteed and tax-free, while an investment return is uncertain and taxable.
What gross return would an investment need to beat an 8 percent loan?
At roughly 26 percent tax on investment income, about 10.8 percent, and guaranteed at that.
Highest interest rate first, or smallest debt first?
Highest rate is mathematically cheaper; smallest debt gets followed through more often. The difference in outcome is usually small.