Paying off a debt earns its interest rate with certainty and without tax; investing has to beat that rate after tax, with room to spare for the risk.
Compare the debt's interest rate with the return you could expect from investing after tax, remembering that paying off debt is a certain return and investing is not. £200 a month put against a 22.9 per cent credit card is worth £22,100 after five years; invested at an illustrative 7 per cent it would be £14,319. Against a 4.5 per cent mortgage the order flips in expectation, by only £889, and reverses again if markets disappoint.
Worked in full in Personal Finance for Beginners by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Every pound used to pay off a debt early earns exactly that debt's interest rate, because it stops interest that would otherwise be charged. It earns it every month, whatever the stock market does, and without tax. So the real question is not "debt or investing" but "is the expected return on investing high enough, after tax, to beat a guaranteed return equal to my debt rate, with enough margin to justify the risk?"
| Input | Value |
|---|---|
| Spare money each month | £200 |
| Period | 60 months |
| Debts compared: credit card, car loan, mortgage | 22.9%, 7.9%, 4.5% |
| Investment return: weak, central, strong | 2%, 7%, 10% |
The comparison assumes the debt is large enough to absorb five years of overpayment, which is true of a mortgage and of most car loans. A card balance would usually be cleared sooner; once it is, the £200 moves on to the next use and the comparison starts again.
Value of £P a month for n months at annual rate r = P × ((1 + r/12)n − 1) ÷ (r/12)
Overpaying a debt at rate r leaves you better off by exactly that amount: the principal repaid plus the interest no longer charged. In Excel: =FV(22.9%/12, 60, -200).
Credit card at 22.9 per cent. The first £200 overpaid saves £3.82 of interest in its first month, £45.80 over a year. Kept up for five years, the overpayments are worth £22,100 in debt that no longer exists: £12,000 paid in and £10,100 of interest avoided.
Investing at 7 per cent. The same £12,000 grows to £14,319, a gain of £2,319, if the 7 per cent arrives. The card wins by £7,782. No plausible investment return closes that gap, and the card's return is certain.
| Use of the £200 | Rate | Value after 5 years | Gain on £12,000 | Certain? |
|---|---|---|---|---|
| Overpay credit card | 22.9% | £22,100 | £10,100 | yes |
| Overpay car loan | 7.9% | £14,657 | £2,657 | yes |
| Overpay mortgage | 4.5% | £13,429 | £1,429 | yes |
| Invest, weak years | 2% | £12,609 | £609 | no |
| Invest, central case | 7% | £14,319 | £2,319 | no |
| Invest, strong years | 10% | £15,487 | £3,487 | no |
Interest you avoid is never taxed. Investment gains outside a tax-free account may be. If returns were taxed at an illustrative 20 per cent as they arise, the investment would need a pre-tax return of debt rate ÷ (1 − 0.20) just to draw level.
| Debt | Debt rate | Return needed |
|---|---|---|
| Credit card | 22.9% | 28.62% |
| Car loan | 7.9% | 9.87% |
| Mortgage | 4.5% | 5.62% |
Tax pushes the mortgage decision closer to overpaying. A tax-free account, or an employer that adds money to your pension contributions, pushes it the other way: money added by an employer is an immediate return that few debt rates match, which is why it is often weighed before overpaying all but the most expensive debt. The exact rules depend on where you live.
All figures are illustrative and none is a forecast. This is education, not advice; your own rates, tax position and the rules where you live decide the answer.
The order in which to clear several debts, and what a starter fund costs while you do, are taken to a number in the free workbook for this book.
Pay off the card in almost every case. Overpaying a 22.9 per cent card earns 22.9 per cent with certainty: £200 a month for five years is worth £22,100 against £14,319 invested at an illustrative 7 per cent. Even at 10 per cent the investment reaches only £15,487.
It is close, and depends on risk and tax. With a 4.5 per cent mortgage, £200 a month for five years is worth £13,429 overpaid, against £14,319 invested at an illustrative 7 per cent and £12,609 at 2 per cent. If investment gains were taxed at 20 per cent, investing would need 5.62 per cent before tax just to draw level.
Any debt whose rate is above the return you can expect from investing after costs and tax, with a margin for risk. Illustratively, against a 7 per cent expected return, a 7.9 per cent car loan is already worth overpaying: it comes out £339 ahead over five years on £200 a month, with no risk.
This article is one calculation from Personal Finance for Beginners. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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