Should Physicians Invest or Pay Off Debt First?

December 1, 2014
Steven Podnos, MD, CFP

Physician clients often ask whether it is wiser to pay off debt or invest in the stock and bond markets. Here's what I tell them.

I’m frequently asked about whether it is wiser to pay off debt or invest in the stock and bond markets.  My usual answer is to pay off debt, any debt, with rare exceptions.  Let’s discuss why.

All calculations related to figuring out which choice makes financial sense must consider the relative cost of the debt and the expected return on investments.  We can only know the cost of the debt. 

If the debt is deductible home mortgage, we can approximate the net cost.  However, with the return of Schedule A deduction phase outs for higher-income families, the ability to deduct home mortgage interest is diminished for many. 

We don’t know the investment returns we’ll make so we have to make some assumptions.  If the debt interest rate is very low (I’d say a net after tax cost of 2 percent is the breakpoint on this definition), you have a reasonable chance of exceeding this with investments in the long term.   Anything higher pushes the choice toward taking the sure thing of paying off the debt.

Most other types of debt do not come with a tax deduction.  I’d suggest the same guidelines as above.  If you are paying more than 2 percent for debt, it's better to pay it off than to invest.

There is a psychological advantage to paying off debt that is impossible to quantify.  I find that families that have paid off debt are also much less likely to take on new debt obligations (and thereby live more within their means).

One of the paradoxical asset allocations I encounter with new clients is the co-existence of debt along with an allocation to fixed income in an after-tax portfolio.   As interest rates on fixed income are exceedingly low these days, this rarely makes sense. 

The only downside I see in taking the money in fixed income and paying off debt is the loss of some liquidity.  Assuming the family has liquidity elsewhere (or available through a home equity loan), they should only be buying fixed-income investments when the debt is paid off.

I’ll admit a bias here, and you might encounter an adviser that wants to use the leverage of investing with borrowed money.  That’s not for me, and I’d suggest it is not for you.