I've seen multiple questions about paying down debt before investing. I'm wondering if there's a simple rule that would cover all cases.
My gut says the rule should be something like:
If you can reliably make more from your investment than it costs to borrow money, then invest, otherwise pay down the debt.
This is essentially the rule I've followed all my life. When you're talking 18% credit card debt or something like that, it's a no-brainier. Sometimes it's not so clear cut. Here's an example where that rule gets fuzzy for my personal situation:
I carry a mortgage on my house, it's the only debt I have. I have the funds to pay it off, but the interest rate is only 3.75%. Over the last 5 years I've averaged much higher return than that on my investments. So it makes sense to me to carry that debt.
Ok, so let's say it makes sense to carry the debt. I currently have $100k equity in the house. Given the simple rule, it would follow that I should pull out the 100k equity and invest that too. Hey, if it makes sense to keep part of the money invested, why not all of it? I don't necessarily think it's a wise idea, but my simple rule doesn't cover this case. So I ask myself, why not?
Maybe I can add to the rule and see if it can stay simple, but be more accurate...
If you can reliably make more from your investment than it costs to borrow money, then invest, otherwise pay down the debt. Stay diversified and maintain a safe level of liquidity.
When I think about the reasons NOT to pay off my mortgage, besides reducing my return, it would also tie up my assets. Houses are not very liquid. You can't trade a shingle for a gallon of milk, or pay your car insurance with a window. So putting too much into your home could make you insolvent. The reason for keeping an emergency fund is to maintain liquidity. Some level of liquidity is important. That level varies based on many things, but everyone should maintain a level of liquidity that lets them sleep at night.
What about borrowing to invest? I feel that this is a bad idea, but in fact I'm already doing it, so this one is harder for me to rationalize. The best reasoning I can come up with is to remain diversified. Essentially the equity in my home is an investment, (albeit an insoluble and low yielding investment). Pulling out the equity would drive up my mortgage. If something happens, like I lose my job in a bad economy, I don't want to be forced to sell my investments, possibly at an inopportune time, to pay my mortgage.
So The choices are:
1. Use investments to pay off the house.
2. Borrow more against the house and invest it.
3. Find some balance between the two and justify it.
In the end, I'm crafting a rule to justify what I'm actually doing. I'm looking for other opinions on this. What are you doing, and why?