Should I Pay Off Debt Or Invest?
Paying down debt is amazing, but so is investing to build wealth. Should I pay off debt or invest first? This is a dilemma that many of us may find ourselves on our financial journey. It can be challenging to determine which route to go first. The truth is, the answer for you will depend on your situation, but before we get into the options to consider, let’s establish some base rules;
This assumes that the following things are in place:
- You have a budget in place and you are able to pay all your bills
- You’re able to make the minimum payments on all your debt,
- You have an emergency fund
- You have some extra funds that you’re looking to decide on the best way to allocate
- Investing, in this case, is not speculative/high risk
With that in mind, here are some key guidelines to help you make the best decision for you.
1. Is There Free Money On The Table?
Do you work for an employer that offers matching contributions towards your retirement/pension plan? If you do, then consider investing at least the minimum amount that your employer will match in order to get that return.
For example, if you make $40,000 a year and your employer matches 50% of your contributions up to 6%. In this case, consider contributing 6% of your salary into your retirement investments so that your employer will match with an additional 3% of your salary. You automatically have a 50% return on your 6% investment before considering any other potential returns in the market.
Failing to invest and passing on your employers’ match means you are leaving free money on the table. No one really wants to do that. You work too hard to do that.
2. Run The Numbers – ROI vs. Interest Rate
An important check to perform in determining whether to prioritize investing or debt pay off is to actually run the numbers. Get the cold hard facts and make an informed decision.
- List out all your debt and the interest rates for each debt
- Do you have high interest debt or low interest debt?
- What is the expected return on your investment? (The average rate of return on the S&P 500 is about 8% but know that performance may differ from year to year)
- Compare the expected rate of return to the interest on your debt
For any debt with rates higher than the expected return on your investment, it is more financially beneficial to focus on paying any extra funds to paying down those debts. Credit card debts often fall into this bucket as they have high interest rates.
On the flip side, interest rates on mortgages and student loans are often lower than the returns on investments. In such instances, it might be more beneficial to allocate excess funds (beyond the minimum debt payment) to investing.
This handy debt vs investing calculator by My FICO can show you a comparison of what happens when you decide to save vs. invest.
How Do You Feel About All Of This?
You’ve looked at the numbers and compared your interest rates to the rate of return. If you’re a person that’s driven by numbers then it’s easy to see through the previous exercise what the better choice might be for you. However, we are humans and each person has their risk tolerance levels. Now the next recommendation is that you look inwards. How do you, and your partner/family feel about the order of priority? Thank about the following questions and answer honestly
- Do you feel burdened/stress by debt and is it important to you to pay it off first?
- Have you written down a list of pros and cons?
- What will keep you most motivated? Paying off debt faster vs. investing more?
- Is there a hybrid approach that may work for you and your situation?
- Have you had the conversation with a few trusted individuals to get additional perspective while acknowledging that it is still your decision to make?
Your Decision: Pay Off Debt or Invest?
The answer to the question ‘should I pay off debt or invest’ is very personal. Personal finance is ‘personal’ for a reason. It doesn’t have to be black or white, or one way or the other. You could do both at the same time in a hybrid approach if that’s best for you (many people do this). Your decision just has to be an educated decision made for you, by you, and based on your personal situation.
When I was paying off my debt, I did both. While debt got the largest chunk of any excess funds in my budget, I started out investing the minimum to get my company match. I increased my 401k-contribution percentage each year as I got raises.
What about you? Have you decided which way to go? What are you considering and why? Please share in the comments below.
Disclaimer: This is for informational/educational purposes only. This does not constitute financial advice.