Pay debt or invest? This is a common question for those who have free cash flow and must make the decision, even more so if they have access to relatively high-interest investments.

In this article, we will use an example with both scenarios to find out which alternative leads to a better financial situation. In the first scenario, Joan pays the minimum installment each month and invests her remaining free cash flow. In the second scenario, Sara pays each month an installment equal to her entire free cash flow, i.e. much more than the minimum installment.

For our two scenarios, we assume that the interest we pay on the debt is equal to the interest we receive on our investments. The result of our study is as follows:

It is better to pay down debt than to invest, even if the interest rate we pay on debt is equal to, higher than, or slightly lower than the interest rate we receive on investments. We obtained this result by evaluating the equity after paying the debt and comparing both scenarios.

Common sense tells us that, at equal interest, it is equivalent to investing or paying debts, however, we decided to calculate it accurately. The result was not what we expected: at equal rates it turned out to be much better to first pay off debts with free cash flow and then start investing.

This result was convincing even without taking into account the costs associated with a loan, such as the insurance that many banks require to set it up.

## How to pay off debts faster?

From our study, it turned out that it is better to pay off debts faster, which is achieved by allocating all the free cash flow to prepay the loan; paying a larger amount to the debt. The faster speed reduces the total interest to be paid.

Once you pay off the debt you will have a free cash flow you can use to pay the next debt or to invest, if you have no more debts.

## How do I know if it is better to pay debt or invest in my specific case?

If you have already been reading our blog, you will know that we are strong advocates of quantitatively understanding the solution and evaluating scenarios before making objective decisions.

This case is no exception: You can download our example and take it as a model to calculate your specific situation.

It is very important to compare comparable scenarios. If you have a debt with a fixed interest rate and an investment with a variable interest rate (stocks, mutual funds, your own business, etc.) you must take into account the difference in risk:

You have 100% certainty that the bank will continue to charge you the installment and insurance no matter what, while your investment has a higher risk, because you have no certainty about your income. In this case, the answer is much more forceful: Pay off your loan first and then use the free cash flow to invest.

## Our case study for deciding between paying debt or investing

We take the case of two sisters: Sara and Judith.

Both take the same loan for 10,000 USD, for a term of 10 years, with an interest rate of 10%. Both have access to the same investment, which gives them an effective annual interest of 10%. Both have a free cash flow of USD 2,000 before paying the loan installment. Both start with no assets.

The difference lies in:

Sara pays each month **the full amount** of her free cash flow, i.e. much more than the minimum installment.

Judith pays the **minimum installment** each month and invests her remaining free cash flow.

The results are as follows:

At the end of 10 years, Sara ends up with assets of USD 15,431 and Judith of USD 11,125.

Sara pays off her debt in year #4 while Judith pays it off in year #10.

As indicated above, we do not include the insurance charged by the bank for the loan and assume that the investment yields a fixed interest of 10%, which is very rare. A safe investment with a fixed interest rate will generally yield returns on the order of 3% or less in inflation-controlled countries.

For Sara’s and Judith’s scenarios to have been equivalent (same wealth at the end of 10 years), the interest on the investment would have to be 15%. If you know of an investment that guarantees a 15% effective annual return, we need to talk!

In our opinion, the result is absolutely compelling. Not only should we pay off debts first, but we should not take on consumer debt in the first place in any case.

## Is the answer the same if my debt is investment debt?

Our simulation is practically for an investment debt; it is possible to use the same model. An investment debt is one that is taken out in order to invest in a specific asset, such as real estate or a business.

If the investment produces a positive cash flow once the debt service is subtracted, you would ideally use it to accelerate the repayment of the debt. This way you will reduce the total interest paid and your equity will increase.

We are in favor of leveraged investments always producing a positive cash flow. If in the previous analysis this condition is not met, it is prudent to reduce the amount borrowed until it is achieved.

A typical example is the purchase of an apartment. In cases where the owner must use part of his salary to repay the debt, in addition to the rental income, the risk of default is high, as the tenant may leave or the salary may be reduced.

## Which is better: pay debt or save?

This is a slightly different case since it is essential to have an emergency fund, which is not an investment, but “insurance” against unforeseen events.

We invite you to read the article “How to save while in debt” to learn more about this case.

## Avoid credits with prepayment penalties or fines

You have seen the importance of prepaying loans. Unfortunately in the 21st century, there are still banks that impose prepayment penalties. And it is natural because by doing so you decrease the amount of interest you pay. This confirms to whom it is convenient and who is affected by prepayment:

It’s good for you and bad for the bank.

Therefore, we strongly suggest that you refrain from taking any type of credit that has this implicit condition. In fact, we suggest you not take any credit at all.

## Conclusion on what is better: Paying debts or investing?

It is better to pay debts than to invest, even if the interest rate we pay on debt is equal to, higher than, or slightly lower than the interest rate we receive on investments. We obtained this result by evaluating the equity after paying the debt and comparing both scenarios.

In our opinion, the result is absolutely compelling. Not only should we pay off debts first, but we should not take on consumer debt in the first place in any case.

We are in favor of leveraged investments always producing a positive cash flow. If in the previous analysis this condition is not met, it is prudent to reduce the amount borrowed until it is achieved.