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Pay Down Debt or Invest: 4 Commonly Overlooked Factors  

Jake - Author/Founder

Hi. I'm Jake, a frugal Canadian Engineer. I believe you can build a great life through frugal living and index investing.

Great news – extra money is available. Perhaps you cut spending, increased income, or received a windfall.

Either way, it is now decision time. Do you use this money to pay down debt, or invest?

Here is an answer I often hear:

“Invest as long as the expected investment returns are greater than the debt interest rate. This will maximize wealth”

This implies that you should invest as long as the debt interest rate is under 7.3%, because global stocks have returned 7.3% over the past 122 years1

This answer is a large oversimplification. There are other factors that must be considered to make an intelligent decision.

In this post, I cover 4 factors of the debt paydown vs invest assessment that are often overlooked.

Pay Down Debt or Invest: The 4 Overlooked Factors

  1. Stock market returns are not risk-free returns, while paying down debt provides a risk-free return equal to the interest rate on the debt.
  2. Holding debt while investing increases your investment risk. This must be considered against your unique tolerance for investment risk. Otherwise, you’ll sleep poorly at night.
  3. Paying down debt provides emotional relief that is not captured by the numbers. Debt paydown can provide that dopamine release, to further motivate wealth building actions.
  4. The term of the debt. A long debt paydown term with a fixed interest rate increases the incentive to invest.

Table of Contents

1. Comparing The Debt Interest Rate to Investment Returns

On the surface, it seems logical to compare the debt interest rate to average market returns. But this comparison misses an important factor.


Paying down debt provides a risk-free return equal to the interest rate on the debt. Stock market returns are far from risk-free.

It is not fair to compare the interest rate on debt to stock market returns.

Example of Risk: Debt Pay Down Vs. Investing

Consider a Line of Credit with a 5% interest rate.

By throwing $1,000 down on the line of credit, you are guaranteed to save $50 per year. You just received a 5% guaranteed return.

Now, let’s say you invested that same $1,000 in an S&P500 index fund for 5 years. You may get a 15% annualized return, or you may get a -5% annualized return. 

After the last decade of steady and exuberant returns, it is easy to forget that markets can go down for long periods of time. 

But history provides many not so friendly reminders of market risk. Just turn back the clock to the lost decade in the US. 

Here you will find that the S&P500 returned -0.6% over the 10 years ended January 2010. That includes reinvested dividends. 

Returns from stocks are far from being risk-free. Therefore, it’s not valid to compare market returns to the risk-free return of debt paydown. 

Infographic: Comparing Debt Interest Rate to Stock Market Returns

Debt Interest Rate: A Rational Comparison

We now know that we can’t compare the debt interest to stock market returns, due to risk.  

But you know what would be realistic? Comparing the debt interest rate to the returns from a risk-free investment.

The US Treasury Note – representing a loan to the US Federal Government – is widely considered a risk-free investment. 

As of writing, you would receive a 2% yield if you bought a US 10-year Treasury Note. This is the risk-free rate 🙂 

It is rational to compare the risk-free return from debt paydown to the risk-free rate. With this logic, it makes sense to invest if the debt interest rate is less than 2%.  

2. Debt and Investment Risk

Investment risk is a core theme in this blog. 

A firm grasp of this concept can prevent you from blowing up. Sky-high returns mean nothing if you lose it all due to poor risk management.  

You also sleep well at night when you take on appropriate investment risk. Sleep is good. It makes you smarter, less grumpy and helps you build muscle. 

So how does this relate to debt? Investing while in debt increases your investment risk. I’ll show why this is the case. 

Investing With Debt: The Same as Leverage

It is possible to borrow money to invest. This is called leverage.

Investing while holding debt has the same effect as leverage. This isn’t intuitive at first. 

I had to run myself through an example to make sure my head was on straight. Let’s go through this same example together.

Note that LoC stands for Line of Credit.



Starts with $40,000 cash.

Starts with $40,000 cash.

Takes out a $20,000 LoC loan with a 3% interest rate.

Takes out a $20,000 LoC loan with a 3% interest rate.   

Uses the $20,000 LoC loan to buy a vehicle.

Uses the $20,000 LoC to put towards investments.   

Has a $40,000 investment portfolio. 

Has a $40,000 investment portfolio. 

Joe uses his LoC to buy the car, however, he could have paid for the car in cash and used the LoC to invest. 

Both Joe and Katie have $60,000 in cash to use. It doesn’t matter how they allocate the dollars. All that matters is that they have the same ratio of debt relative to investment portfolio size. 

Holding debt while investing is equivalent to using leverage, and leverage increases your exposure to investment risk.   

Debt and Your Unique Risk Tolerance for Investment Risk

Leverage increases the risk of your investment portfolio. Very few have the risk tolerance for a portfolio of 100% stocks, yet alone a leveraged portfolio of 100% stocks.

Taking too much risk can result in your blowing up. This is bad. 

We all have a unique ability to take investment risk. Some unique factors include:  

  1. Investment time horizon, often related to your age.
  2. Job stability.
  3. Predictability of your expenses.
  4. Weather you own or rent your shelter.
  5. Your emotional stability in the face of market volatility.
You can learn more about your tolerance for investment risk in this Intro Guide on Investment Risk. 

How does this relate to debt pay down vs investing decision?

Someone with a higher risk tolerance can take more investment risk. They can prioritize investing relative to someone with a lower risk tolerance. 

Consider a paydown of a loan with a 3.5% interest rate. A 40-year-old bartender may focus on paying down this debt, while a 25-year-old federal government worker may pay the debt minimums and invest what is left. 

Debt vs Invest: Your Emergency Fund

Don’t even think about investing until you have an emergency fund of 3-6 months of essential expenses. 

An emergency fund prevents you from dipping into your investments during a market downturn and selling at a loss.

Your ability to endure market downturns increases your ability to take on risk, plus you feel good about your self-control after the fact.  

In addition, an emergency fund acts like a stress relief valve when life hits you hard. 

And trust me, life will hit hard, eventually. Maybe your car breaks down, or you need to fly out to help a close family member, or your hot water tank explodes. Maybe all of these happen at the same time.

An emergency fund keeps your money anxiety levels low, so you can vector your energy to the important things in life.

I even like the idea of a small $500 emergency fund before starting to pay down high interest debt. 

Once the high interest debt is gone, aim to build up an emergency fund size equal to 3-6 months of essential expenses. Only then does investing become a consideration. 

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3. Debt and Human Behavior

Debt and the associated payments are like a ball and chain. Paying down $1,000 provides a greater increase in freedom than investing $1,000.

Debt pay down can offer emotional relief that is not captured by a strict numerical comparison (my inner engineer rebels).

This is why I never touch 0% loans for consumer products, even though it may be a good decision according to the math. Note I am assuming we avoid all the sneaky small print tactics on 0% loans that often trigger extra fees.

By taking on a 0% loan I choose to spread the cost of a  product or service over many months. This erodes the strong habit of paying for things up front. 

I unwilling to compromise this habit, with exception of mortgage debt. 

4. Debt Term

I’d lean towards the investing side of the spectrum if the debt has a longer-term.

As the time horizon expands, stocks become less risky and therefore the comparison between the interest rate and market returns becomes more realistic.

For example, I’d be more inclined to invest if I had a fixed-rate 10-year term mortgage at 3% relative to a variable mortgage at 3%. 

We can also look at this through the lens of risk. Debt with a longer fixed term has lower interest rate risk because rates are set for the duration of the term.

Lower interest risk on your debt can increase your ability to take investment risk. In response, you may learn in the direction of investing over debt paydown, depending on the rate.

Jake's Personal Debt Paydown Threshold

I’ll share my threshold for debt paydown. 

If I had consumer debt I would immediately and aggressively pay down all consumer debt, regardless of the rate. This is a behavioral choice –  the idea of consumer debt makes me unhappy. 

But I’d consider student loan debt and mortgage debt differently. 

If I had this type of debt, I’d make minimum mortgage payments and invest the rest until the rate exceeded 3%. At this point, I’d start considering a more aggressive mortgage paydown. 


The decision to pay down debt or invest depends on multiple factors that are unique to you.

When making the decision, most correctly account for the debt interest rate relative to expected investment returns. But we often fail to consider other critical factors such as: 

  • It is not logical to compare risky investment returns to the risk-free returns of debt paydown. 
  • Holding debt while investing increases your investment risk, by acting like leverage. 
  • Debt paydown brings a psychological benefit of increased freedom. 
  • The term of the debt can influence the debt paydown vs investment decision. 

I hope you come out of this post with a better ability to  decide how to allocate your money between debt paydown and investing.