Should I pay down debt first, or start investing now?

The Rule

There are three components of any investment:

1. The Risk
2. The Expected (or average) Return
3. The Taxability

You often hear about “Risk vs. Return”, but the actual return you get is of course affected by taxes.

Investments

When you make an investment, you are taking some amount of risk (at least in the short term) with the expectation that you will make gains.

For example:

1. You could put your money into a savings account at around 0.33% that’s practically nothing, but the risk is very low. Even if the bank failed, the government would step in and make things right. The main long “term” risk is that interest rates might get even lower.
2. You could put your money in something like the S&P 500. Here the expected returns are much higher (based on historical data), but short term returns are quite variable. You could easily have a large loss in your first year of investing. Your overall effective risk lowers as time goes on, but it doesn’t reach a theoretical zero chance of losing money until you get to around 20 years. What’s more, if you are investing in US Dollar based securities from Japan, you also have exchange rate risk. Still, you can expect an overal average of something like 7% after taxes.
3. If you invest in the stock market in Japan, you might be able to expect something like 3-4% dividend income from high dividend stocks, which would be a bit less after taxes.

The point here is, you have a range of options, but the higher of a return you want to chase, the less certainty you will have.

Debts

The same is true from the bank’s point of view. If they lend money for a mortgage, it’s relatively low risk since they could always sell the house. If they lend you money via a credit card loan, well that’s high risk since you might decide not to pay it back.

From the bank’s point of view, they should charge more when loaning money to riskier borrows, and they should charge less when the loans are secured.

Sadly, though, from your point of view, your bank loan is “risk free” in the sense that there is pretty much zero chance that the bank will say “Oh you don’t have to pay as much this month”.

They may count your loan as risky because they don’t know 100% if you will have the will and ability to pay – but your obligation is to pay in full, on time, every month, like clockwork.

What this means is that if you have a credit card balance at 12%, a student loan at 6%, a housing loan at 1%, and a shopping loan at 1% – they are all “risk free” because you know how much you will owe, and when. The only real risk is that the interest rate might change.

Debts as Investments

You can think of debts as investments with negative returns. Your 6% student loan is an “investment” which returns -6%, risk free.

Paying down your debt, then, is reducing the balance of your -6% investment, and when compared to your current situation, is almost the same^*1 as investing in a risk free product at 6%.

This is because paying down 10,000 yen of this 6% loan has almost the same effect as investing in an offsetting financial product that earns 6% risk free.

Example:

For the sake of simplicity, let’s say interest is calculated on your average balance, charged or paid at the end of the year, and compounded yearly. We’ll also assume a world with no taxes.

For every 10,000 yen of your loan, you will owe 600 yen at the end of the year.

For every 10,000 yen you invest, you will make 600 yen at the end of the year.

Scenario 1:

You owe 20,000 yen, so you end up owing 1,200 yen.

Cash Flow : -1,200 yen

Scenario 2:

You owe 20,000 yen, so you end up owing 1,200 yen.

You invest 10,000 yen, so you end up making 600 yen.

Cash Flow: -600 yen

Scenario 3:

You owed 20,000 yen, but you paid down 10,000 yen at the end of last year, so now you only owe 10,000 yen.

Cash flow: -600 yen

Summary

You can see here that the end result of paying down your loan by 10,000 yen is the same as keeping your 20,000 yen loan and investing 10,000.

Where things go wrong: Risk & Taxes

Many people understand this to some extent and say “Well investing can make sense when when I have debt, so long as the investing returns are higher than the interest rate on my loans!” In effect, they ask themselves “Why should I pay down my 3% student loan when I could invest that money in the stock market where I could get 10%?”

Fair though, but there are two problems:

Risk – As mentioned above, the debts you owe are effectively risk free, except for interest rates in many cases. Paying them down is in effect investing risk free. So, the choice between paying down your student loan debts or investing in the stock market isn’t a simple 3% vs 10% question, it’s a question of which is better: 3% risk free vs. 10% with high risk.

Taxes – In the example above, we ignored taxes, but leaving aside mortgages and business loans, interest on most consumer loans is not tax deductible. Investment income, on the other hand usually does have taxes taken out. Assuming you are investing in a NISA account, you may be able to avoid this up to certain limits. Nevertheless, if you are comparing paying down a 3% debt vs a 10% pre-tax investment return, the real choice may be between a 3% risk free investment vs. a high risk investment with a 6-7% post tax expected return.

Comparison with other risk free investment alternatives

Normally, you might have the following choices for risk free investments.

1. Bank Accounts – Less than 0.5% return
2. Term Deposits (1 year term) – <=1% return
3. Japanese Government Bill (1 year term) < 1.5% return
4. Japanese Government Bonds (10 year term) < 3% return

All of these returns are nominal pre-tax numbers.

As of the time of this writing, even if you buy a 10 year government bond, you will only get a 2.785% return. This is the highest it’s been in over 10 years, but still quite small compared to most consumer debt.

So if you pay off a 3% student loan, you can get a better effective return than you can get even by investing in 10 year government bonds.

Not only that, but if you have credit cards, of other consumer debt, chances are you owe 6%-14% APR.

This means your choice comes down to “investing” in paying off a 6%-14% loan, tax free and risk free, or trying to make that much risk free which is … completely impossible.

The Bottom Line

For any loan with an APR above about 4%, paying down the loan instead of investing in a risk laden financial product that will likely return less after taxes is the obvious choice.

^*1 I say “almost”, because there may be differences in compounding periods, methods, interest rate adjustment timing, etc.

Mortgages

The situation with Mortgages is a bit murky. With the average home loan interest rates still under 1%^*3, and the fat that home loan interest is generally tax deductible, things are a bit less clear cut than the consumer debt examples above.

The expansion of the Shin NISA program which enables tax free investment opportunities for amounts on par with some home loans swings things even farther towards the investing side.

For example: Paying down a 1% home loan may save you less than that 1% since it was tax deductible. At the same time, if you were lucky enough to get an average of 8% in an index fund in your NISA no taxes need be paid on that gain.^*2

This means you might be weighing a 0.7% risk free return vs. a risky 8% return. Here, the risk vs. return trade-off seems very reasonable.

Still, if you suddenly lost your job during an economic downturn while the stock market is in a bust cycle you may well wish that you had paid off your mortgage before investing in risky assets.

The main point is this: Investing in stocks, gold, bonds, etc. is really not defensible if you owe any kind of consumer debt such as credit cards, etc. Mortgages are typically much lower interest rates and tax deductible, so considering your options is a sane thing to do.

^*2 In Japan, at least. Some funds pay taxes overseas first before distribution.

^*3 My choice of words here is intentional. Property investment loans tend to be well above 1%, currently hovering around 2.5%.

The Exception

If your place of work has a 401k (or other DC plan) with matching contributions, then for every 10,000 yen you invest, you might be getting an additional 10,000 yen from your employer. Add this to the tax deferment feature, and suddenly you might be able to get 20,000 per month added to your DC account while your paycheck is only dropping 6,000-7,000 yen. That means an immediate and roughly a 300% return for the amount you invest each month.

I would invest in any account with matching to the maximum allowed before paying off low interest loans, assuming my cash flow situation was stable.

Bear in mind, though, that 401k accounts in Japan can not be withdrawn from, borrowed against, or liquidated except in exceptional circumstances. I would be ironic if you were missing credit card payments while you had millions of yen in the bank that you couldn’t touch.