Cross-posted from Putanumonit.

Since I wrote Get Rich Slowly I’ve received a steady stream of questions regarding personal finance. The most common of those is: should I prioritize investing or paying off my debts?

Get Rich Slowly wasn’t meant to break any new ground, just summarize some of the best advice online in a clear way for my readers. So, I thought I could just look up the existing best advice on debt vs. investing. I did, it sucks.

A lot of places tell you to invest if the return you’re expecting is higher than the interest on your debt, but that completely ignores risk. Taking a loan at 20% to invest in a highly speculative venture with expected returns of 20.1% isn’t smart investing, it’s a reckless gamble that’s likely to leave you bankrupt. The Balance, one of the most popular personal finance websites, mentions the importance of risk-adjustment but is too lazy to do the math explicitly. It also recommends maxing out your Roth IRA (expected return 6-7% with a fair bit of risk) before paying off credit cards (20%+ interest rate), which is utterly insane.

Risk adjustment is difficult and subjective, but there’s no escape from putting a number on it ourselves.


I like to think of debt as an anti-investment. Let’s say you have a $10,000 loan which charges 5% interest, and you also have $10,000 invested with a risk-free after-tax return of 5%. The two would cancel each other out – your cash flow is the same as if you had neither one, namely zero. So, if you pay off the loan, you can think of it as gaining a risk-free investment with the same after-tax return as the loan’s interest rate.

What if instead of paying off the loan you invest the money? Then instead of the risk-free investment, you gain a different one. For example, if you invest the money in an S&P 500 US stock index, you will gain an investment that should return 7% (or 6% after paying capital gains tax), albeit with quite a bit of risk.

Thus, the question of paying off the debt becomes a comparison between a risk-free investment and your best alternative investment option. The question becomes: what risk-free rate of return is equivalent to your best available investment? If you pay a higher interest on your debt than that, you should pay it off. If the rate you’re paying is lower, you should invest. In our example, if you like holding a risky 6%-return stock fund about as much as a risk-free 3%, you should pay off any loans that charge you more than 3%.

This may not seem like an easier question to answer, but we can attack it from several angles. At the core of this decision is a consideration of how much the risk-free part is worth to you, which is going to be different for each person. I will use the S&P 500 as the example of investment under consideration, but you should consider your own considerations instead.

0. Better loan

If you can get a loan for a lower interest rate than your current debt, you should just take the new one out to repay the old one. Duh. You could have an opportunity to borrow at lower rates for any of the following reasons:

  1. You improved your credit rating.
  2. You married someone with a better credit rating (I should add that to the matrix).
  3. You got into a degree program and can get student loans (which are cheaper because they’re not dischargeable).
  4. You bought/inherited/stole an asset that can be used as collateral.
  5. You got over yourself and borrowed the money from your parents.

Remember to calculate the interest rate on an after-tax basis too, so a 6% mortgage can really only cost 4% if you can deduct the mortgage interest from your taxable income. Taking a mortgage to pay off worse loans is a smart thing to do.

And with that out of the way, here are some reasons why a risk-free investment (which is what you’ll “gain” by paying off the loan) may better than the S&P 500 even with a lower rate of return.

1. Arbitrage

Whatever your preferred investment option is, there’s probably one with a higher return that’s just too risky for you. This can be something like junk bonds, an emerging markets index fund, or even simply a levered S&P 500 fund (which multiplies the risk and return). If you had a risk-free investment, you could invest part of it in the high-risk high-reward option and end up with a better overall deal.

Here’s a numerical example that may or may not make this clear:

The S&P has a yearly volatility of 15-20% (call it 17%) and a return of 6%. Let’s notate this [6,17] The MSCI world index (global stocks) has higher returns but is also riskier, perhaps [8,25]. In a vacuum, you may prefer the former. But what if you had a risk free 5% return [5,0]? You could invest 40% of that in the MSCI and end up with 60%*[5,0] + 40%*[8,25] ~ [3,0] + [3.2,10] ~ [6.2,10], or 6.2% returns with 10% volatility. That’s certainly a better deal than [6,17].

If you didn’t follow the example or you don’t like using yearly volatility as a measure of risk, you’ll just have to trust me that this principle holds. Back in our original formulation, paying off some part of your loan and investing the remainder in something with a higher yield can result in better returns and a lower risk than investing the whole amount in the S&P.

2. Utility of money

A good reason to be risk averse is that the value you derive from every extra dollar diminishes with every dollar you have. Going from $100,000 to $200,000 (whether in wealth or income) will give you a bigger happiness boost than going from $200,000 to $300,000. This means that a guaranteed $200k is better than a coin flip between $100k and $300k. There’s research showing the happiness depends on the log of income, so you’d need the coin flip to be between $100k and $400k to equal a safe $200k.

(I previously used this fact to propose a new measure of economic inequality.)

If you invest $100,000 in the S&P 500, after 16 years (at 6% return) you’ll have $250,000 on average. But it could be a lot more or a lot less, somewhat like a $100k-$400k coin flip. But to get to $200,000 you only need a risk-free investment at 4.6%.

3. Planning

This is closely related to the point above: a guaranteed return is better than a volatile one because it allows you to plan ahead. Whether you’re planning hit the milestone number for retirement, buy a house, or get that last bit of uranium ore from Amazon you need for your “peaceful” nuclear program, knowing how much money you’ll have in the future makes it easier to plan. If your future returns are volatile, you will probably need to aim for a higher number to guarantee you have enough to reach that all-important critical mass.

4. The Beta of your life

A risky investment isn’t just bad in itself, it also contributes to the overall risk of your economic life. If you live and work in a developed economy, almost everything you can invest in will be positively correlated with everything else, and with your career as well: US stocks, global stocks, corporate bonds, real estate, natural resources, even government bonds (especially during crises).

This means that in the worst-case scenario everything can turn sour at the same time: the economy tanks, your investments lose value, your job is at risk, etc. A risk-free investment can isolate you from that pain, or, conversely, debt will make that pain much worse. This again should make risk-free investments more attractive even at lower return rates, especially if the rest of your eggs are in the same few baskets.

There are some possible investments that aren’t positively correlated to everything else, such as cryptocurrencies (maybe). But if you’re reckless enough to take out loans for the purpose of buying crypto, I have a bunch of JacobCoins to sell you.

5. Risk aversion

Humans have evolved to be averse to risk and unnecessary gambles. Some of this risk aversion is rational in the case of investments – see points 1-4. But even the irrational part is still part of you, and having volatile investments will fray your nerves and cost you sleep regardless of the math you do.


I know it seems weird to compare existing choices to an option you don’t really have (a risk-free investment with arbitrary return), but that’s exactly what debt is. Or rather, that’s exactly the opposite of what debt is.

Different people will give different weights to the five factors I listed, but it’s important to remember that they’re additive, not exclusive. The more you care about any of them the lower the return you would be happy with if you could get it risk-free, and thus the lower rate of interest on your debt that you’ll hold.

Most of my own money is in stock index funds. I expect a 7% return from my retirement savings (401k and IRA) because they’re tax-free, and 6% return from my medium-term savings. I’d be happy to replace those with a 4% and 3% return, respectively, if I could get it risk-free.

This means that I:

  1. Don’t hold any debt at above 4%. If I had any, I would sell some short-term investments to pay it off right away.
  2. Will happily borrow money at 2-2.5% to invest in stocks, and will consider borrowing at 3-3.5% only if it goes to retirement (for example, if I need it to max out the yearly Roth IRA cap).
  3. Will happily lend at 5-6% for something close to risk-free, such as a short-term loan to a close family member or friend, because that’s a better deal for me than my investments.

And finally, since good investments with returns above 6% are very hard to come by, if you have any debt at 5-6% or more you should almost certainly pay that off before investing a single penny. It’s a very un-American piece of advice to hand out on July 4th, but it’s the truth.

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42 comments, sorted by Click to highlight new comments since: Today at 5:15 AM

Good article but I take issue with two points

The S&P has a yearly volatility of 15-20% (call it 17%) and a return of 6%. Let’s notate this [6,17] The MSCI world index (global stocks) has higher returns but is also riskier, perhaps [8,25].

You seem to be confusing past returns with prospective returns.

When you take into account markets that completely imploded, confiscations, and selection bias (advanced countries = countries that were successful in the past) the likely prospective figures are much lower.

For the MSCI world I am not sure where the figures come from. Since 1987 the return was less than 8% before inflation.

Also anyone who takes the US market as a representative of likely future returns should be aware that it was the top performing market over the last 100 years. There is no compelling reason to think such outperformance will continue into the future.

I that people factor in future returns more like 4-5% after inflation. This is more like the long term returns from "the triumph of the optimists" but also allowing for markets that went to zero, which the book excludes.

And the variance means you may get nothing near that return. There have been multi-decade periods of virtually no return.

Don’t hold any debt at above 4%.

It depends. If debt is tax deductible then it can make sense to hold it. Or based on the size of the opportunity.

As a general principle you are right.

Update (from MSCI data and using a web inflation calculator

US 1969-present return after CPI deduction 5.7% World 5% PA which was not higher than the US (note this has a degree of survivorship bias) Australia 4.4% (as an example of a country that did reasonably well until then)

This is a 50 year period.

For those thinking that they can pick the winning countries in the future, consider what the winning countries looked like in 1900. England Russia Germany Argentina... the US was then a wild frontier economy recovering from a ruinous civil war, and no-one would make a big bet on that... predictions are hard to make, especially about the future.

Don’t hold any debt at above 4%.

It depends. If debt is tax deductible then it can make sense to hold it. Or based on the size of the opportunity.

Note that this is in the section of the OP's advice to themself, and presumably accounts for them already checking for tax-deductible opportunities and opportunity costs.

There is no compelling reason to think such outperformance will continue into the future.

The market disagrees with you.

the US was then a wild frontier economy recovering from a ruinous civil war, and no-one would make a big bet on that... predictions are hard to make, especially about the future.

which is why you hold a globally diversified portfolio. You don't place 'bets.'

Given that there are big institutions that rather put money into government bonds with negative interests rates then putting the money on the stock market, what exactly do you mean with "The market disagrees with you"?

You definitely shouldn't expect the US stock market to perform as well over the next year as it did on average over the last 100 years. (Nor for the world to perform as well as the US did.)

To first order, equity returns are driven by a combination of earnings and price changes. Here is the S&P 500 P/E ratio over the last 100 years, a reasonable measure of the "price" of stocks. The price has more than doubled, which generated 1% of the return, earnings have generated 6% average return, for a total return of 7%.

Given that the price is now very high relative to historical levels, a pessimist might expect them to go down on average---in general, if something has done well because the price has gone up a lot, that's a reason that future returns will be low rather than high.

But even setting that aside, and assuming that prices will keep increasing at ~1%/year, you should expect the 6% average return from earnings to go down to 4%, since you are now paying $25 for a company that makes $1 in earnings (rather than $15). So that would take total real return down to 5%.

In fact things are even worse than that, since $25 are earnings while at full employment, and you want to average over the next 20 years which includes recessions. This adds some more drag, getting you down to maybe 3% returns before price changes.

(I think realistically prices should be expected to go down rather than up, based on any kind of reasonable historical extrapolation. I'd estimate >1% per year price drop over the next year in expectation. So now we are down to <2% real return.)

If you mean that the market predicts the US to outperform the rest of the world, that's also not really right, it expects the rest of the world to have higher returns than the US (but also to have higher volatility).

the price is now very high

What does the outside view say about that claim?

ie, why do you expect what you said not to be priced into current expectations?

Are you willing to bet on <2% expected real returns?

What does the outside view say about that claim?

Which claim?

If you spend $100 to buy an asset that produces $4/profit per year, all else equal you should expect to make less money than if you had spent $100 to buy an asset that produces $6/profit per year. I think this is pretty straightforward, and (unsurprisingly) it's consistent with the historical data. If you try to generalize from few enough datapoints with enough noise you can manage to lose the signal in the noise.

ie, why do you expect what you said not to be priced into current expectations?

What does that mean? Which asset price would you expect to be different if in fact smart investors expected equities to have low returns?

Are you willing to bet on <2% expected real returns?

How would you operationalize that bet? At the end of the year, I give you market returns on $1, and you give me $0.02 + inflation?

You'd be a fool to make such a bet, and (other than the risk that you'd default) I'd be a fool not to take it. It's a pure arbitrage: I take the bet with you, then borrow $1 for a year at the going interest rate (which is about 0.3%+inflation), then buy $1 of equities, and I make 2% per year with zero risk.

The problem is that betting odds don't reflect probabilities, they reflect the probabilities of possible worlds weighted by how much I value money in each world. To the extent that markets are efficient, everyone's betting odds ought to imply a 0.3% real return for the market over the next year, because that's the risk free interest rate.

You could instead bet something other than money, something that isn't more valuable to me in worlds where I have less money. In that case I'd still be happy to sell market returns at 2%+inflation. (In fact I'm basically making that bet every day I decide not to be leveraged in the current market.)

>In fact I'm basically making that bet every day I decide not to be leveraged in the current market.

that's what I was curious about.

The market disagrees with you.

I would be interested in any evidence for this. The existence of compelling reasons for outperformance at current prices would suggest that current prices are wrong.

which is why you hold a globally diversified portfolio. You don't place bets

OP was I think suggesting that the SP500 performance was something that one could expect ongoing by investing in the US market. Or you could diversify.

I agree that betting it all on one market is probably foolish. (But may do very well)

There is no compelling reason to think such outperformance will continue into the future.

The market disagrees with you.

What market instruments express opinions on the future returns of US equity investments? Everything I can think of serves to express an opinion on present prices of equity investments or on things like the future risk-free rate of return, not the future return on, e.g., the S&P500 index.

Why is the anti-investment risk-free? You might declare bankruptcy, discharging your debt for free. If you expect that this might happen in the future, paying off your debt is the same as an investment which crashes once you go bankrupt.

Yeah, ignoring the option to declare bankruptcy or foreclose, effectively bounding your downside, seems like a major gap in this analysis. Especially as many jurisdictions usually allow people to keep significant assets (primary residence, 401ks) in bankruptcy. (Though on the other hand since 2005 US bankruptcy law obliges many filers to accept "repayment plans" for some fraction of what they owe, so it's not quite "discharging your debt for free".) That said I guess the most common debt for people reading this post is probably nondischargeable student debt; it makes sense if it's mainly talking about that.

There are behavioral issues to address as well. Your advice is pretty solid, so I'm not advocating major changes, but it's worth mentioning these possible confounding issues (really one issue stated 3 ways):

  • For most, the small daily decisions (whether and how much to spend on optional consumption) FAR outweigh the rare, larger "financial planning" decisions. It's far better to save more than to optimize where you put it.
  • For many, the fact that they _have_ any credit card debt is testament to the fact that they spend badly. If one has a "set level" for tolerable amount of debt, then paying it down is useless because you'll soon borrow back to it.
  • Some investments are psychologically or legally difficult to cash out. If you have imperfect spending/saving habits, these investments are better than their risk-adjusted RoR would imply.

Basically, if you care about your distant-future self more than you care about your near-future self, it makes sense to optimize your investment ecosystem to remind your near-future self about that preference.

All good points, but you are missing one consideration. Paying off debt is a perfectly risk-free investment, but also an investment that is difficult to withdraw. I have a couple of months salary in a bank account earning ~0% interest, while paying a couple percent interest on a mortgage. In theory, I am throwing money away and should pay off as much as I can. The difference is that the money in the bank account is easily available if I need it.

You are absolutely right that anyone paying 20% interest on credit card debt should pay it off before thinking about investments.

Insolvency is very expensive! You can map it into the framework outlined in the post by assigning insolvency some interest cost of x% where x% >> 4%. If you don't like assigning a made up interest cost to being insolvent you can instead think of the whole thing in terms of a higher order representation such as utility. It then follows that you should cover your insolvency before covering most debts.

Note that 10 year high-quality corporate bond yields are currently at 4%, and 10 year US debt is <3%, so a low-risk 10-year loan at 5% is a pretty incredible deal. Your recommendation to pay off debt at 4% before investing seems relatively safe, though if you think your future earnings are very large relative to your current wealth you might want to couple that with a small leveraged equity position (e.g. using a leveraged ETF) so that you can at least get compensated for some risk.

Your 7% expected returns estimate is probably (significantly) too optimistic right now.

On one level, the fact that there are multiple companies willing to lend to me at X percent and to expend funds marketing these loans to me is a pretty strong indication that there aren't investments of comparable risk that pay X percent. If there were, the companies would make those investments themselves without involving me. So I operate from a presumption that capital costs me more than it pays me, and I minimize my debts accordingly.

Is your position that at a time where there are government bonds out there with negative interest rates, everyone should withdraw all their money from nearly all investments because having money under your mattress beats those negative interest rates?

I would use a bank lockbox instead of a mattress. But that situation does indicate that the markets have more invested funds than they have investment opportunities, and people should take enough money out of the market that only investment opportunities offering reasonable risk-adjusted returns get funded.

It also implies that a lot of retirement plans that assume constant ~8 percent returns are delusional, and that most people will have to work longer than they wish. Such is life.

Bank lockboxes have fees, which typically work out to more negative interest than the most negative actually-observed government-debt interest rates. (Indeed the operating & insurance costs of bank lockboxes at scale are basically a lower bound on how low government-debt interest rates can go in the market; this article from the European interest rate lows in 2016 suggest insurance costs of 0.5-1%.)

For small amounts of money, FDIC insured bank accounts are suitably secure. Which is what I and most people actually use.

If the FDIC fails, we're probably beyond a financial fix. Time to go loot a Hot Topic and start calling myself Doctor Humongous.

FDIC doesn't insure safe deposit boxes. It does insure your checking account balance, but your bank still has to figure out somewhere with a nonnegative interest rate to put your money (since the FDIC insurance triggers only after the bank itself is wiped out). Or find a way to charge you enough fees to make your effective interest rate negative.

Sure, but they're a bank. Hopefully they have a competitive advantage in finding profitable places to lend money; that's supposedly their whole job. I don't, so I'm probably better off leaving it to them (as long as I have sufficient insurance in case they're bad at their job, which historically they often are).

Your rules of thumb at the end appear very pragmatic in that they're easy to follow, and I use a similar system for myself. Do you happen to have a rule of thumb for how much return you require for a specific risk?

"happiness depends on the log of income"

I subscribe to the idea that increased wealth has approximately logarithmic utility. This is very tangential to the topic of your post but... I'd be curious to hear your thoughts about a corollary stemming from this that one should be willing to take increased risks with additional capital due to its logarithmic utility? What is your take on that, should an individual with assets / income beyond their needs be willing to take increased risk?

You seem to value the psychological factor of having debt at zero. I don't think that makes sense.

I think there's some ambiguity in your phrasing and that might explain gjm's disagreement:

You seem to value the (psychological factor of having debt) at zero.


You seem to value the psychological factor of (having debt at zero).

These two ways of parsing it have opposite meanings. I think you mean the former but I initially read it as the latter, and reading gjm's initial comment, I think they also read it as the latter.

The crappiness of the English language. I meant the first.

Why not?

Suppose I feel happier and suffer less stress when I am in no debt than when I am in some debt. Why shouldn't that be a factor in my decisions? It surely isn't wrong to value feeling happy and unstressed.

If careful consideration leads me to conclude that those feelings make my life worse rather than better, then perhaps I should try to change them. But as long as I have them, what's wrong with taking them into account when deciding what to do?

I think you are in agreement with ChristianKl (i.e., you both think the OP overlooks the emotional disutility of knowing that you have debt), but your tone seems to me to indicate disagreement.

Nope. I think the OP doesn't overlook the emotional disutility of knowing you have debt, and that seems to me sufficient justification for what I think Christian is objecting to.

What text from the post suggests accounting for the emotional disutility of indebtedness?

Here's a quote that to me seems to argue against it:

The question becomes: what risk-free rate of return is equivalent to your best available investment? If you pay a higher interest on your debt than that, you should pay it off. If the rate you’re paying is lower, you should invest.

Following this algorithm suggests investing in a risk-free 3.01% return before paying off debts costing a net 3% in interest.

There's a bit of section 5 that accepts emotional disutility of volatility, but that's not the same thing.

As for ChristianKl, they comment that to them it doesn't make sense to value indebtedness at zero, agreeing with you that the disutility should be accounted for.

Oh! I've been interpreting Christian's comment differently from you. Christian, could you clarify whether "value the psychological factor of having debt at zero" means (1) "place zero value on the psychological consequences of having debt" (which I think is what rossry has been taking you to mean) or (2) "place positive value on the psychological consequences of having zero debt" (which is what I was taking you to mean)? Thanks!

I think probably you're right, and in any case you're right that section 5 is about the emotional disutility of volatility; I was misremembering it as having said something about the emotional disutility of being in debt. Sorry about that.

... And having written that, I see that adrusi has made the same point about ambiguity. I'll leave this here anyway.

OK. Then I confirm that I agree with you: there surely is (for some people if not all) a psychological difference between having debt and having no debt, and it's surely (for most of those people if not all) in favour of the latter, and Jacob's article might have been improved by taking that into account.

But here's a counterargument: he isn't claiming to offer a complete analysis of debt and why one might choose to take it on or not; he's pointing out one thing about debt, its "anti-investment" character, and looking in some detail at that. When I started writing this comment I wrote "would have been improved" at the end of the paragraph above, but the more I think about the point in this paragraph the less I believe that, hence the weaker language that stands there now.

  1. What if you have lots of debt (>$50k us) and no investments or assets?

  2. Is attempting to pay off a debt still the same as a "risk free" investment if you've had the experience of attempting to pay off a debt, only to have the owed party accept your money and then not lower the debt? I.e., if you have a known and verifiable risk that handing the owed party money won't lower your debt (say, due to perfectly legal bureaucratic shenanigans), is that the same as a high-risk anti-debt?

  3. If you have no assets and no liquidity, are your debts even real?

1. Briefly, you'd want to establish some minimum amount to cover emergencies (maybe $10-$20k), because the opportunity cost of not having available cash to deal with an emergency is huge. After that, I'd recommend paying off the debt if you think you'll almost certainly pay it off eventually (rather than declaring bankruptcy).

2. I guess that would be like an investment that's risk-free, but sometimes the money you want to invest in it gets stolen. In any case, my model is about debt/investment trade-offs, not about dealing with scammers. Don't pay scammers, that's the only model I have.

3. I think it's quite useful to assess an actual probability of you declaring bankruptcy, perhaps by multiplying the chance of you not having enough income to cover living expenses over some time frame. I think income also matters a lot more for debt repayment than assets, let alone liquidity.

Can't tell if you're just being snarky/self-pitying, or if you're serious. I'll try to answer.

1) Do you include future earnings in your "no assets" description? If you're off the grid and not dealing with money, this post probably isn't for you. If you plan long-term not to make more than you spend, you're probably also not ready to optimize on these dimensions. If you expect to make more than you spend during some future time period, you will have an asset about which to make choices.

2) You need to include risk of fraud and mistakes in any decision you make. This advice isn't "make payments that might get swallowed", it's "pay down debt". If you're not actually reducing your debt, there are probably better investments.

3) Debts that you honestly expect to never pay are not real debts. It doesn't follow that if you have no monetary assets and no liquidity that you never will, though.

Related: if you think buying a house is an obvious win please use the NY times rent vs buy calculator. Tl;dr if buying vs renting was an obvious win the market would arbitrage that. In most popular cities buying a house costs more than renting in the long run due to speculation and bias.

An anecdote for an anecdote: I made up and plugged in some numbers that roughly corresponded to buying my last (rented) apartment, and the calculator said it'd be cheaper than my rent by ~10%.

Tl;dr if buying vs renting was an obvious win the market would arbitrage that.

As I understand it, lots of the win comes from limit-one-per-person tax advantages, so "the market" can't straightforwardly arbitrage it away.

In any case, along the lines of the OP's section 4 above, the typical person should probably, ceteris paribus, prefer some investment in some real estate over additional investment in whatever market portfolio they already have, because not-perfectly-correlated assets add expectations but less-than-add volatilities. I think the calculator you linked is getting this wrong.

A single house in a single market levered up 5x isn't the good kind of diversification and will make your expected portfolio performance worse. Lot's of people diversify into a reit index, don't know if that's optimal or not.

A single house in a single market levered up 5x isn't the good kind of diversification

Hm, I can see your point. Are you saying because you've worked through a back-of-the-envelope calculation, or are you just guessing? (Me, I was just guessing.)

and will make your expected portfolio performance worse.

Do you mean "will make the expected dollar-returns of your portfolio worse", or are you making a claim about the expected utility-adjusted returns?

Debt is a way to fund investments. You take on the debt to buy a productive asset. With said production, you repay the debt, you have your asset, and benefit of future unencumbered production.