Decades ago the correct answer to this question was usually to invest instead of paying down debt balances. In recent years that logic has reversed.
To understand this change let’s first consider the business model used by a bank. Banks borrow at wholesale rates, say 2% or less. They then turn around and lend that money to consumers like us for home and car purchases, and for student loans. They charge us anywhere from 4% to 8% on these loans (and up to 25% on credit card balances). The key is that the rate at which they lend must be higher than the rate at which they borrow. The same principal applies to households.
You should only invest rather than pay down debt if your investment can be expected to yield a significantly higher rate than what you are paying to service your debt.
Years ago, we could obtain subsidized student loans at 2% rates, and invest that money in risky stock markets earning on average 8% to 10%. If we wanted to avoid the high risk associated with stocks, we could invest in US Government Treasury bonds yielding 5%—for a guaranteed, risk-free profit of 3% or thereabouts (i.e., 5%-2%=3%). Under such circumstances it made sense to borrow up to the allowable maximum, invest the loan proceeds, and make the smallest debt payments we could get away with so we could keep that cheap borrowed money as long as possible.
But today’s landscape is dramatically different. Subsidized loans with very low rates have gone the way of the Dodo bird, i.e., they’re extinct. Instead, most student debt carries interest in the 6% to 8% range—ruinously high rates. Meanwhile, what are our investment alternatives? With interest rates at near-historic lows the best we can earn on riskless government securities is 2%. Corporate bonds, which are less risky than stocks but still risky, may yield around 4%—less than our cost of borrowing—making it more advisable to repay debt.
Stocks are the only asset class offering expected returns in the same ballpark as loan rates. But stocks are very risky—we may instead lose a lot of money on stock investments and still be on the hook for the high interest loans.
Assume your loan rates are 8%. Paying down debt gives you the certainty of avoiding future obligations with rates of 8%, while investing in stocks gives you a possibility but not a guarantee of earning around 8%. Logic suggests that removing the certain debt obligation is better than chasing speculative gains.
I’ve been somewhat conservative in assuming that loan rates and stock investment returns are comparable at around 8%. These numbers make the decision very clear—pay down the debt!
Your circumstances may leave some gray area. If your student debt carries only a 5% interest rate, and you believe you can average returns of around 10% on stock investments, then making the investment instead of paying down debt could make sense. The final decision is up to you.