Should I Invest or Pay Down Debt?
If I have extra money left over after paying my expenses every month, should I invest that money or should I pay off my existing line of credit debt?
Residents continue to graduate medical school with significant amount of debt. Based on the 2020 AFMC National Graduation Questionnaire, medical students enter residency with a median debt of $100,000, and over 15% of medical students graduating with over $200,000 in debt.
As a majority of medical students enter residency with debt, most Residents will have to face the decision of when to pay off their debt. Residents can try paying off their debt during their training, or we can defer paying off debt until we become staff physicians.
As discussed in our Foundations content, the direct cost of carrying debt is the interest charge. Depending on the type of debt, interest charges can be fixed or variable (meaning that the rate can change over time). The Line of Credit (LOC) that most residents have access to consists of a variable interest rate, as the LOC interest rate varies with the national prime lending rate.
Similar to debt, which accumulates interest charges over time, money that is invested may grow in value over a period of time. Invested money benefits from the value of compounding interest. Depending on the cost associated with carrying a particular amount of debt, an individual may consider borrowing money to purchase an investment, such as stocks or real estate. The goal with this financial maneuver is the earn more on your investment than the interest that you are being charged on the debt used to purchase that investment. Debt that is obtained for the purpose of earning money is considered “good debt” in the world of personal finance. Examples of “good debt” include tangible investments, such as stocks or real estate, as well as intangible investments that may indirectly increase your wealth, such as taking on student loans to pay for an advanced degree. “Bad debt” is considered the debt that is used to purchase items that do not directly increase your wealth, such as spending on credit cards for consumer items.
While the terms “good debt” and “bad debt” seem like value statements, almost everyone will have some form of each type of debt. As medical trainees, we all will spend money on consumer products that do not increase our wealth, as well as spend money on items that increase our wealth (such as medical school tuition). For many residents, spending will exceed your earnings for a period of time, especially during the first few years of training. When your spending exceeds your expenses, you do not have extra money left over to begin saving or pay off your LOC debt. However, as you progress through residency and into your career as a staff physician, you will ideally reach a point when your earnings exceed your spending (see the “Lifestyle Creep” Lesson of Module 3 of the Foundations program to learn more this phenomenon and how to prevent it from occurring). When your earnings exceed your spending, you will have extra money that can be used to build your savings or pay off your debt.
Given the benefit of compounding interest, the potential earnings from the money that you invest increases the longer that money is invested. That means that there is a benefit to investing early! However, that extra money can also be used to pay down debt, as the interest charges compound overtime as well.
Note, different investments carry different risks and higher rates of return also means greater risk and volatility. Some investments are also more difficult to liquidate. For example, it’s simple to take funds out of a high interest savings account, but much more time consuming and onerous to sell a rental property. The cost of taking funds out of a high interest savings account is low. The cost of selling a rental property may mean paying commissions to a real estate agent, including other expenses like being penalized thousands of dollars for ending a mortgage term early. More on rates of return and risk of loss below.
Choosing to prioritize paying off debt over building savings can be difficult given the number of benefits the come with pursuing either option. To review how to evaluate this decision more, let’s work through a case.
Shelia is a PGY-4 resident in a 5-year residency training program. She carries a line of credit debt of $100,000 at an interest rate of 2.2%. She has not paid off any of her line of credit debt thus far during residency, as she lives in a location with a high cost-of-living. After this year’s tax return, due to her accumulated tuition tax credits, Shelia will be receiving a sizeable tax refund of $2500. Shelia has not contributed any money yet to her savings accounts, nor her TFSA or RRSP.
Should Shelia use the $2500 to pay down her LOC debt, or should she begin contributing to her savings by purchasing an investment in her TFSA or RRSP?
While there are many nuances to this decision, let’s review the simple math behind it.
Step One: Calculate the Interest Savings on the LOC
If Shelia uses the $2500 to pay down her debt on her LOC, she will save the interest charges on the amount she uses to pay off the debt. That means at her current interest rate of 2.2%, paying off $2500 would save Shelia $55 annually on interest charges (2.2% x $2500). It is important to keep in mind that the interest rate on your LOC is variable, and as such, it will increase if the prime interest rate increases in response to the economic climate. That means that the $2500 you paid off on your debt could end up saving you more money in the future, should the interest rate increase.
Step Two: Calculate the potential return on an investment
Let’s say that instead of paying down her LOC, Shelia is interested in purchasing an investment, what kind of return would she expect from the investment?
As discussed in our Foundations lessons, there are a variety of investments available. Certain investments have a guaranteed return with the principal investment being protected (meaning that your initial investment will not lose money), such as savings accounts and Guaranteed Investment Certificates (GICs). The interest returns on these type of fixed income products is typically quite low, but let’s see if they are a good option for Shelia.
On review of her bank’s GIC offerings, Shelia finds that the highest paying GIC available is a 3-year Market Growth GIC that pays up to 6% interest. Typically, GICs that are available for longer terms will earn more interest and certain GICs have a minimum and maximum interest rate. In this case, if Shelia buys this GIC, she will be unable to access the $2500 for 3-years. After the 3-years is over, the GIC may pay her 6%, which works out to $150 on her $2500 investment – not bad!
However, over the same three-year period, Shelia could have saved $55 per year in interest costs on her LOC if she used the $2500 to pay down her debt. This would have worked out to $165 in savings – which is more than the maximum return on the GIC!
This calculation demonstrates is that there are rarely, if any, investments that will have a guaranteed return and protected principal investment that will pay an interest rate that exceeds the interest rate on our LOC. Why would this be the case? Typically, the LOC offered to medical students is one of the lowest cost debt products that a bank offers. If a bank is offering a guaranteed return on an investment, it is unlikely that they will pay more interest to a customer than what they would receive from their own debt products.
So that means that if we want a greater return, we have to look at different investment products, such as equity investments. While there are many different options for equity investments, a common offering that many investors consider are exchange-traded funds (ETFs). Total portfolio ETFs consist of a balance of equity and bond ETFs to meet the different risk tolerance levels of investors. For the sake of this exercise, we will use the return of a hypothetical ETF with a 80% equity allocation and 20% bond allocation. Some real-life examples of this type of ETF available in Canada would be VGRO or XGRO (stock ticker symbol).
If Shelia invested the $2500 into this type of portfolio, what return would we expect? Compared to the fixed income products, equity investments do not have guaranteed returns and your investment can increase in value, decrease in value, or stay the same. While nothing can reliably predict future returns on equity investments, we can look at the historical returns to get a sense of what returns may be possible.
Here are the past returns for a sample portfolio of 80% equity investments and 20% bonds over the past 25 years (as of December 2020). It is important to note that equity investments tend to yield greater investment returns than fixed income investments, but also carry a greater risk of losing money.
|Timeframe||% Return of Hypothetical 80% Equity/20% Bond Portfolio||Annual $ Earned (based on a $2500 investment)|
|3-Year Return (annualized)||8.60%||$215.00|
|5-Year Return (annualized)||8.91%||$222.75|
|25-Year Return (annualized)||7.23% (SD: 9.84%)||$180.75|
|Lowest 12-month return||-26.57% (Mar 2008-Feb 2009)||$664.25 loss|
As you can see, the annual return of this type of investment would, on average, exceed the interest cost savings the Shelia would realize by paying down her debt ($55 annually). However, it is important to note that the equities market has been yielding very high returns over the past 5 years. It is anyone’s guess whether this trend will continue into the future! If we look back at the past 25 years, we can also appreciate that this type of investment can lose money. For instance, if Shelia invested her $2500 during the period of the Great Recession in 2008 (Mar 2008-Feb 2009), she would have lost $664.25 if she sold during this time and realized her losses. As such, a prospective equities investor needs to appreciate that while the investment could grow, it could also lose money over the course of the year. Patient and experienced investors know that, based historical data, over the long term their investments should rebound. Losses only happen when they are realized. Just like gains (profits) only happen when you actually sell for a gain.
Step Three: Evaluate your investment time horizon
Now that we have compared the potential returns of paying down debt to investing, it is important to consider how long your timeline is for your potential investment. As you can see from the investment returns table above, there can be significant year-to-year variation on the investment return.
If we look at the 80/20 portfolio above, the average return over the past 25 years is 7.23% annually. That means that despite the year-to-year fluctuations of the returns, on average, this type of portfolio grew in value overtime.
However, what if Shelia needed that $2500 in one year? In the past, we saw that this same type of portfolio could have lost as much as 26.57% in a single 12-month period. While this portfolio eventually gained its losses back over the subsequent years, if an investor needed to sell all of their investment during that negative 26.57% year, they would have lost a decent amount of money.
This is why it is important to consider your investment time horizon. Your investment time horizon describes the length of time that the money you are saving will be invested and not be withdrawn. For many people, investments are purchased to eventually use in retirement. Therefore, the investment time horizon for a brand-new staff physician may be well over 25 years, depending on their desired age of retirement. Financial advisors tend to recommend that investors have a longer investment time horizon (meaning that the investor plans to not withdraw the invested funds for a greater period of time) when choosing higher risk, but higher reward investments, such as equity investments. By having a longer investment time horizon, the investor should worry less about the year-to-year fluctuations in the value of their investment, as they do not have the immediate need to sell their investment.
So, if Shelia does not anticipate needing the $2500 soon and she feels comfortable keeping that money invested for a long period of time (potentially until she retires in 25 years), she may earn more money by purchasing an investment now, rather than paying off her debt.
But let’s say Shelia has a shorter investment horizon as she plans to buy a house when she graduates residency, and she will need that $2500 for a down payment next year. How should she save this money?
If you have a shorter investment time horizon, it’s more important to conserve our principal investment rather than maximizing your return (as you will need to use the cash soon!). As such, most financial advisors would recommend choosing a conservative investment product, like a GIC or savings account, as discussed earlier.
Based on our review so far, Shelia has the following options for her shorter investment time horizon:
|Action||Pay off Debt
(eg: LOC at 2.2%)
(eg: 80/20 Portfolio)
|Fixed Income Investment
|1 year Return (%)||2.2% (guaranteed)||Unknown
Average 25 year return = 7.23% (SD: +/-9.84%)
|1 year Return ($)||$55||Unknown||$6.25|
While Shelia could earn more money by investing in equities, she could also lose her money. On the other hand, if Shelia pays off her debt, she is guaranteed to ‘earn’ a return of 2.2% by saving the 2.2% interest rate (which exceeds the guaranteed interest rate that she could earn on her GIC).
At the end of the day, there is no right answer. Would Shelia rather have a guaranteed return of 2.2% by paying off your LOC? Or would she prefer to take the risk of an equity investment, with the potential of losing money, but also the potential to gain more return? The decision will be influenced Shelia’s personal financial risk tolerance. There are a number of free tools available online to assess your own financial risk tolerance.
The Psychology of Debt
In the above case, Shelia had to decide between paying off debt or increasing her savings. While you can guide your decision by comparing the mathematical returns of each option, there are other factors that may be considered.
From our case, if Shelia decided to pay down her debt, she would not only save 2.2% in interest costs, but she has also reduced her overall debt burden. While it’s easy to measure the interest cost savings that are realized by paying down debt, the indirect consequences of carrying debt are much harder to measure.
While the evidence available in personal finance pales in comparison to the other areas of study, there have been a few studies on the psychology of debt. A series of experiments by Raghubir and Srivastava (2008) revealed that consumers tend to spend more when they are using credit rather than debit or cash. The authors theorized that the rationale behind the increase spending with debt instruments is that there is a delay between when you incur the expense and when the expense must be paid. Therefore, the consumer does not experience the financial impact of the expense until several weeks later. In addition, it can be difficult to keep track of spending when multiple different expenses are being charged to the same account. For instance, it can be difficult to know how much you have spent on entertainment in a particular month when you have restaurant charges, grocery expenses, cell phone charges, utilities, and car expenses all on the same bill.
Furthermore, carrying a significant amount of the debt may be associated with negative mental and physical health effects. A systematic review and meta-analysis by Richardson et al. (2013) found that increased levels of unsecured debt (such as our student line of credit) were associated with depression, suicide, substance use disorders, and psychotic disorders. While these are not necessarily causal relationships, it is important to acknowledge that carrying large debt loads may come with negative consequences beyond the interest charges.
You must honestly gage your risk tolerance when investing. Some people look forward to a significant drop in the markets because they view this as a buying opportunity because everything is on “sale”. But if you can’t stomach too much volatility, you may wish to invest in financial instruments that are associated with less risk.
The decision to invest or pay down debt is complex and depends on several factors. While it is important to reflect on the potential cost-savings of the decision, evaluating your personal financial risk tolerance and investment time horizon will help you reach a final decision. While interest rates are low, it may be more financially beneficial to prioritize building savings over reducing your debt. However, if the investment time horizon is shorter and the savings will need to be accessed soon, paying down debt will provide you a more secure guaranteed return. Furthermore, it has the added of benefits of (1) showing a future mortgage lender your ability to pay down debt (2) increasing your credit score and (3) enhancing your ability to qualify for a home mortgage. It is also important to acknowledge that the decision to carry more debt can have other indirect consequences, such as increased spending and potential negative health effects.
References & Useful Resources
Richardson T, Elliott P, Roberts R. The relationship between personal unsecured debt and mental and physical health: a systematic review and meta-analysis. Clin Psychol Rev. 2013 Dec;33(8):1148-62. doi: 10.1016/j.cpr.2013.08.009. Epub 2013 Sep 10. PMID: 24121465.