Personal finance can be confusing, especially when you first wander down the rabbit hole. When you first start actually care about your financial situation and future. When you start to sift through the vast mountains of advice available on the internet relating to how you should be saving, investing, and spending your hard-earned money.

The biggest question most people have making this journey tends to be along the lines of “Ok, I know I should have an emergency fund, I know I should max out my pension contributions, I know I should have 0.00 of debt, I know I should be putting money aside for medium-term expenses, I know I should be investing regularly…but I only have 342.29 in my account and am overdue on 3 credit cards – where do I start?!“.

Although the answer is necessarily circumstance-specific, one fundamental question underpinning the above is if it’s better to pay off debt or to invest? This is what we will be attempting to answer today.

Numbers don’t lie

And the answer comes easily, when the question is viewed from a purely mathematical perspective: there is no always-correct or even usually-correct answer. It very much depends on the rates: the interest rate being applied to your debt (Annual Percentage Rate or APR) and the return you receive on your portfolio of investments (Rate of Return or RoR).

As a simplified example, imagine an individual with 10,000 of debt and 1,500 to “spend” each year on either investing or paying off said debt. This person has 2 options: pay some amount less than 1,500 towards paying off their debt and invest the rest (what I call the “investing strategy”), or pay the maximum possible until the debt is fully repaid then start committing the whole sum towards investing (the “debt payment strategy”).

Turns out that when the rates are the same (APR = RoR), each of the above strategies will result in the same value of the portfolio after 20 years (around 23,000 when both are 5%). However, when there is a difference between these rates, the strategy selected starts to make an impact on the outcome. With RoR = 2.5% and APR = 7.5%, the investing strategy would yield a portfolio value of roughly 13,500 compared to the debt payment strategy yielding about 17,500. In the opposite scenario, with RoR = 7.5% and APR = 2.5%, the investing strategy would generate a portfolio of value of nearly 33,000 but the debt payment strategy would result in a portfolio value of just under 30,000.

Why does this happen? Because of compounding. With a high APR, you compound debt at a quicker rate, meaning that paying off debt can have outsized benefits compared to investing. With a high RoR, you compound the value of your portfolio quickly, meaning investing early can be more beneficial than paying off debt.

So, from a purely mathematical perspective, it really depends on what rates are associated with both your debt and your investments.

It’s circumstantial

But not every decision can and should be made purely by looking at numbers (thank God). In reality, the situation is often more nuanced with exact circumstances playing a major role in the outcome. The first thing to note is that these calculations make assumptions about rates. From an RoR perspective, these are likely to be estimates at best. What will be the return of the FTSE 100 in 2022? “I’m not sure” would be an understatement. APR is also sometimes uncertain and/or subject to change.

Then there are the more practical considerations. Are you overdue on your debt? Is it collateralised? Are you subject to a (massive) bailiff knocking on your door asking for your Samsung 46″ 8K QLED TV if you don’t pay? I would probably prioritise 1 or 2 debt payments before I thought about making investments in that case. The structure of the debt is also important. Are we talking about student loans? If so I would typically recommend not paying more than you have to and investing instead – payments are only collected as a % of income. A mortgage is another unique proposition due to the time horizon, size, and nature of the secured asset (you have to live inside it). It’s unlikely there is a general solution in that particular scenario (similar to the decision to buy or rent the property in the first place).

The case for paying off debt

Although the decision clearly depends on the exact situation we are considering, that doesn’t mean we can’t enter the process with useful principles and heuristics that can inform said decision. Debt is a constant in this world, and it is not always a bad thing. It all depends on the kind of debt you have.

Suppose you’re a business owner who has taken up a loan in your company’s name; you could reach out to a real estate agency to help you purchase a property, which you can then put out on rent or sell later. You could repay the loan in instalments through the rental income you generate from it and retain the property. You also have the option of letting the property appreciate in value and selling it when you have made a good return on investment. This can be considered a form of “good debt”

A “bad debt”, however, costs you money, which can lead to great financial loss. And in worst-case scenarios, it can leave you bankrupt. A few examples of bad debt include car loans, personal loans, credit card dues, and payday loans among others. You should prioritise debt repayments based on how it impacts your financial health. Here, common personal finance knowledge tells us the following:

In most circumstances, pay off debt first before making investments.

This advice exists for a reason. But why? The numbers tell us that it depends on the rates. Reality tells us that it’s circumstantial. So why the recommendation to pay off debt first?

For a start, most people who are in debt will find, after running the numbers and assessing their individual situation, that paying off debt is clearly the better move. This is largely a consequence of the fact that individual debt (outside of mortgages) has a relatively short-term time horizon over which rates are applied. APRs are high. Usually a lot higher than the 5-10% one could reasonably expect from investing in financial assets.

This higher APR is also guaranteed, investment returns are not. Even if probability is in your favour (your RoR is probably going to be larger than your APR), what actually happens in reality is a different matter. This manifests itself both in the size of your investment returns and your ability to pay off the debt in the future if you opt with the investing strategy. Even if you are earning enough to cover the debt payments – what if you lose your job? Even if you have a healthy emergency fund – what if your fancy new car needs serious repairs? In these circumstances, missing a few investment opportunities is far less severe than missing multiple debt payments.

Clearing out the dues you have, and preparing for the dues you might have in the future is an excellent way to delegate your finances. It removes the risk-related anxieties that you might have, enabling you to maximise your returns on investment later. If you have reinforced your personal finance in a way that you can mitigate current financial risks and potential debts, you can make informed and well-calculated investments. These investments can, indeed, be diversified into simple bonds or fixed assets, or even into larger assets, like investing in Melbourne, Florida real estate, or a similar place with lucrative options.

The mitigation of debt is an especially important consideration when you look at your credit rating. If you get in a hole with debt, not only is it hard to get out of, but your record will also be permanently scarred as a result. Getting access to credit will be more difficult and more expensive in the future. There is no record of this kind for making investments. A few bad periods of debt payment is a big deal, a few bad investments, not so much.

This is lucky, because investing is significantly harder than paying off debt. The latter involves literally just transferring money. Even I can do that. Investing, on the other hand, requires a multitude of decisions to be made such as what platform(s) to use, what to invest in, how much to invest, etc. which annoyingly complicate the situation and, despite what some people say, do not all have straightforward answers. There are many more ways to make a mistake, make a wrong decision, get scammed or semi-scammed, etc.

This is probably one of the reasons why paying off debt just feels a little bit better. There is a simple target, and a simple way to get there. It’s incredibly psychologically rewarding to see that total debt number reduce and reduce and reduce until it’s gone. It’s a burden, both financially and mentally, and removing this burden gives you a sense of financial freedom that investing just can’t.