Expensive debt first
As long as you have high interest debt, paying it off is often the better investment. It gives you a sure, tax free return equal to the loan's interest rate.
Learning objective: After this lesson you can explain why paying off expensive debt is often the best investment.
If you pay 12 percent interest on your overdraft while hoping to earn 7 percent with stocks, you lose money every year, however well the stocks do.
A worked example
An example: Tom owes €2,000 on his overdraft at 12 percent. That costs him €240 a year. If he pays back the €2,000, he saves those €240 for certain, every year. He'd need a lot of luck to beat that with an investment, and even then he'd owe tax on the gains.
The interest threshold
A rough line that has proven useful: pay off anything above about five percent interest first. If the rate is lower, such as on an old mortgage, it can make sense to invest alongside.
Ordering several debts
If you have several debts, there are two ways. The cheapest is to clear the one with the highest interest first. But many people stick with it better if they tick off the smallest debt first, because the first loan paid off gives them a boost. Both ways beat doing nothing.
Paying off a loan is like an investment with a return equal to the effective interest rate, only without any risk. On top of that, interest you save isn't income, so there's no tax on it. An investment therefore has to earn clearly more before tax to keep up. In Germany the flat capital gains tax including surcharges is about 26 percent. To beat a loan at 8 percent there, an investment would need about 10.9 percent before tax, and it would have to be certain as well.
Five percent as a benchmark
The five percent line isn't a fixed rule. It comes from comparing with what a broadly diversified stock portfolio might roughly be expected to earn after tax. When interest rates rise generally, the line moves up, when they fall, down. If you want to be precise, compare your loan's effective rate with your own expected return after tax, and knock a bit off the return because it isn't certain.
Order of repayment
On the order with several loans: paying off by interest rate saves the most overall. Paying off by size, smallest first, is kept up more often according to behavioral studies. The difference in cost is usually smaller than the difference between sticking with it and giving up.
Summary
- Paying off debt gives a sure, tax free return equal to the loan rate.
- Above about five percent interest: pay off first, then invest.
- The path you stick with beats the mathematically perfect one.
Did you get it?
Why can't you simply compare the return of paying off debt with an investment return?
Because it's certain and tax free, while an investment return is uncertain and taxable.
How much would an investment in Germany need to earn before tax to beat a loan at 8 percent?
At about 26 percent tax, roughly 10.9 percent, and with certainty.
Highest interest first or smallest debt first?
Highest interest saves more, smallest first is kept up more often. The difference is usually small.
What others often ask about this
Pay off debt first or start investing?
Compare the interest rates. An overdraft at 12 percent certainly costs more than an ETF earns on average. Clearing expensive debt first is a guaranteed return of exactly that rate.
What about a cheap loan, such as a mortgage?
Then investing alongside it can make sense. What matters is that the repayments stay safely affordable and an emergency fund is in place.
Check your understanding
Your task
You owe $3,000 on a credit line at 11 percent and have $3,000 in savings. Calculate how much interest the debt costs per year and how much an investment at an assumed 6 percent would earn before taxes. Then enter your own numbers into the pay off or invest calculator.
Sources and further reading
- The text of § 32d of the German Income Tax Act, which sets the flat 25 percent tax rate on capital income. View source ↗
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