At the start of their financial independence campaign, a lot of people ask if it’s better to pay off debt or invest their money. After all, investing should grow money over time, whereas debt might only cost small payments.

Generally, it’s better to pay off debt before investing. This is because you need an unrealistically high return on investments to beat the interest charged on most retail debts. The exception might be where the interest on the debt is very low, such as with a mortgage or student loan.

This is not financial or debt advice. If you are struggling with debt, the resources page on the Money Advice Service is worth looking at for specialist debt assistance.

There is no shame in being in debt. It happens.

Good debt and bad debt

If you read a personal finance book – particularly Rich Dad Poor Dad – you might read about debt being “good” or “bad”.

“Good” debt is meant to be debt that you use to buy assets that generate more money than the debt will cost.

“Bad” debt is all other debt.

Generally, debt is bad. Even debt that starts off as good can turn bad if the assets aren’t as productive as you expected.

Good debt is the only kind of debt that you might want to keep so that you can invest more. It’s often called “leverage”.

Examples of this might be:

  • a student loan that helps you get a degree which you use to earn money
  • a mortgage that helps you with a buy-to-let property
  • a margin loan on an advanced margin trading strategy – but only if you’re really good at leveraged trading, which most people aren’t
  • a business loan that helps you set up as a self-employed person or business owner.

I’m not really talking about good debt here. That said, a word of caution: good debt can quickly become bad debt if you overdo it.

No, I’m talking about bad debt.

Bad debt is pretty much everything else. It’s a burden.

If you’re taking out debt, you probably don’t have money

This isn’t a dig. I’ve been in debt before, and it’s no joke.

In principle, you only need to borrow money because you don’t have it. There are exceptions, but you usually borrow money to extend your spending power beyond what you currently have in your account.

If you’re in the camp where debt is a genuine choice – you probably don’t need it.

That’s not the same as credit cards. I use credit cards all the time. That’s because I can use my credit card provider as a type of insurance, but I usually pay my balance off straight away.

Anyway, this is important because it means that you probably won’t have the money to pull you out of debt if you use it to invest and it all goes wrong. The situation can quickly spiral out of control, and it’s hard to pull out of it without a lot of determined effort.

Can you out-invest debt?

Debt has an interest rate. Bad debt particularly sucks, because that interest rate tends to be 15-50% Annual Payable Rate.

There are investments that have in theory performed better than this. Some leveraged investing can do this on a good year. Crypto has done this some years. In theory, you could invest at a faster interest rate than bad debt.

You probably won’t though. Sorry to ruin this illusion. This is because the situation has to be perfect. Here’s what needs to happen for you to out-invest debt.

1. You have to pick the right investment to start with

It’s possible that a psychic is reading this blog and laughing at me. Then again, a psychic investor shouldn’t need to read this blog, right?

Even top analysts pick poor investments. Most people – me included – can’t. Instead, we buy a few, which is called diversification.

Diversified portfolios tend not to have the kinds of highs that will grow faster than bad debt. That’s part of the reason for diversification: so that lows and highs are less obvious.

This means that you can only really beat bad debt if you pick a specific, focused investment that will grow more than the debt will take from you. That’s pretty difficult, if not technically impossible.

2. You need to buy at the bottom and sell at the peak

Bitcoin might grow 60% one year. Getting 2x leverage on the S&P500 might give you 50% return that year. Shares in Tesla might skyrocket in value.

Even if it does, though, the chances are that you won’t get that. This is because you’d have to know the best possible time to buy (when prices are lowest) and sell at the perfect time (when prices are highest).

3. The returns have to happen before the debt comes in

Most debt compounds frequently and you pay it off monthly. The interest starts on day one. You need to be getting that miracle growth from day one if you want to beat it.

Some debt has an interest-free period. For example, you might have a 0% interest free period on a credit card. It’s possible to use this to invest at 0%, but… at some point that debt’s coming in.

The debt will come in.

Will your returns happen before then? Maybe. Maybe not. Maybe that 60% growth you were hoping for happens, but you’ve already had to sell the investment to pay the first payments back.

A lot of the time, investments have an average expected return. Most investments are volatile, meaning that their price moves around. It’s usually expected that you’re going to hold them for years, not months.

All the growth might come in at the end after years of being underwater, doubling your loss.

Generally, you should pay off debt instead of investing

Given that you’re almost certainly not going to out-invest retail debt, you should probably pay off debt before you invest.

That said, there’s one specific exception that I can think of where you might want to invest instead.

Mortgage debt

Your home probably isn’t an asset. It doesn’t put money in your pocket if you can’t sell it because you’re living in it.

You might be house hacking or running a business from a home office, which I guess would turn it into an asset, but for most people it’s a liability.

It’s a cheap debt, though. At around 2-3%, you’re quite likely to out-invest it, when you average out over a couple of years. There’s no such thing as a “sure thing”, but it’s a pretty good bet.

Banks will also struggle to enforce mortgage debt. Your bank doesn’t really want to repossess your house if it can help it, banks aren’t set up to sell houses. Plus, it doesn’t look good. It’s bad optics.

We compromised: we overpaid our mortgage until we hit 60% LTV. That’s because the 60% point gave us a lot of freedom over what we do with the house, such as if we want to rent it out and go travelling.

In conclusion: should you pay off debt or invest?

I’d argue that:

  • Not all debt is bad. Some of it is good debt that can be used to buy money-making assets.
  • Most retail debt is bad debt. If in doubt: it’s bad debt.
  • You probably can’t out-invest bad debt. The odds are not in your favour.
  • The exception might be mortgage debt. Investing might be more effective than overpaying your mortgage.

Overall, generally you should try to pay off debt before investing. It doesn’t make sense to invest while carrying the debt burden.