When Not to Pay Down Debt

June 09, 2016

In her new book, What Your Financial Advisor Isn’t Telling You, our CEO, Liz Davidson, writes about how paying off debt can be your greatest investment. As they say, a penny saved is a penny earned so if you pay down credit card debt at 19% interest, it’s like earning 19% guaranteed tax-free. But as with most financial planning guidelines, there are exceptions. Here are some situations where paying down debt may NOT be your best investment:

You can’t pay your bills. If you’re in severe financial difficulty, make sure you prioritize keeping a roof over your head, your car in the driveway, the lights and water running, and food on the table even over paying the minimum on your debts. Don’t jeopardize you and your family’s basic well-being to pay down debt that you might have to liquidate in bankruptcy anyway. In fact, if you think you might file for bankruptcy, don’t borrow or take withdrawals from a retirement account to make debt payments since those assets are generally protected in a bankruptcy.

You don’t have sufficient emergency savings. To avoid the problem above, you’ll want to have some emergency savings. You should have enough cash to cover at least 3-6 months’ worth of necessary expenses.

You can consider your ability to borrow from a retirement plan or the Bank of Mom and Dad as part of your emergency resources but not lines of credit since they can easily be cancelled, especially if you’re in between jobs or the economy is weak. This money should be someplace safe like a savings account or money market fund. Yes, the interest you’ll earn is probably much less than the interest you’re paying on debt, but how do you value avoiding eviction or foreclosure on your home?

You’re not contributing enough to max your employer’s matching funds. The only thing that beats saving 19% interest is earning 50% or 100% on your money. If you’re not maxing the match, you’re leaving free money on the table and getting behind on your retirement saving.

Your debt is costing you less than 4-6% in interest. If the interest on your debt is below 4-6% (after any tax deductions you get for the interest), you could probably earn more by investing extra savings (particularly in a tax-advantaged account) than you’d save by paying down that debt. That’s why they call low-interest mortgages, car loans, and student loans “good debt.” If the interest rate is between 4-6%, your decision depends on how aggressive an investor you are. Conservative investors would likely be better off (and happier) paying down the debt, while more aggressive investors are likelier to earn more by investing instead.

None of this is to suggest that paying down high-interest debt isn’t generally a good idea. These are just the exceptions. If you’re able to pay your basic bills, have sufficient emergency savings, are maxing the matching in your retirement plan, and have high-interest debt, paying it off IS your best investment.