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The dilemma of whether to pay off debt or invest your money is a burning question finance experts get all the time.
I know, that’s less than satisfying.
But there are many factors to consider, such as:
- How much debt do you have?
- What are the debt interest rates?
- Are you talking about investing in the stock market just for kicks?
- Do you have any retirement money set aside at all?
- Is one of the investments in question an employer-matched 401(k)?
And the list goes on.
This isn’t very helpful on the surface. So let’s cover some details that will help you make an informed decision about whether you should pay down debt or invest first.
Or should you be doing both?
What Is the Rule of Thumb About Paying Debt vs. Investing?
This pits the interest rate of your debt against the money you’d potentially make in the stock market or other type of investment — also known as your rate of return.
This brings us to the question…
What Is Your Rate of Interest vs. Rate of Return?
Your rate of interest is the fee you pay a lender for borrowing money from it.
If you look at a debt statement such as a car loan or credit card bill, you’ll find the interest rate the lender’s charging — and you may need a magnifying glass. It’s usually in the tiniest font your lender can get away with.
A rate of return is the amount of money you earn or lose from an investment over a certain time period (usually a year).
Here are some facts to consider when comparing your rate of interest vs. rate of return:
- Generally, any debt with an interest rate higher than around 6% can be considered high-interest debt.
- Debt that carries high interest is not good to hold onto. Get rid of it as soon as possible.
- Long-term data shows an average return on investment of 8-11% over several decades. Before investing, keep in mind that some of those years were big stinkin’ losers.
- Your rate of return is always a safe bet when you apply it to paying off high-interest-rate debt. It’s certain that you’ll get to keep the money you were paying out in interest.
- The rate of return is much less stable when it comes to investing your money. You’re never guaranteed any earnings.
Hopefully, these guidelines can help you evaluate what’s best for your financial situation.
Should You Pay Off Loan Debt or Invest?
Loan debt can mean many different things. Is it a car loan or a student loan? Does it charge a high or low interest rate? These variables must be considered as you decide what’s best for you.
Should I invest if I have a car loan?
There’s no hard-and-fast answer to this one. Car loans are often considered short-term debt because they have a set timeframe for payback.
Depending on your loan interest and money situation, it may be fine to stash away some retirement cash while paying off your car.
- Most car loans are simple interest, rather than compounding loans — which is great. Interest won’t build on interest while you’re paying it back.
- Car loan interest rates tend to be fairly low, especially compared with credit debt. That’s in your favor as well.
- Find out what your loan interest rate is so you can evaluate that piece of the puzzle before investing.
- If you’ve got a comfortable amount of cash left over after loan payments and living expenses, there’s no harm in putting money into something like a Roth IRA account that pays compound interest.
- Bonus points if you can put a little extra cash into your car loan payoff each month while contributing some funds to your IRA or a 401(k).
Should I pay my student loans or invest?
If you have the burden of school loans, the interest rate and amount you owe will likely have a big influence on whether you decide to pay them off completely before investing any money.
Sometimes it’s helpful to get a good visual on the numbers. A “pay off loan or invest” calculator lets you plug in a bunch of figures to see how they fit together.
Other factors to consider are the repayment options you’ve chosen, whether you qualify for loan forgiveness, and whether you’re able to pay more than the minimum payment each month.
Keep in mind:
- Federal student loans generally have a low interest rate, while private loans can have outrageous rates like a credit card. High-interest debt may need to be paid ASAP before anything else.
- Depending on your repayment choice, the amount you pay each month could be tied to your current income. This sometimes results in a fairly big payment. You may not have anything left over to invest, which solves the dilemma right there.
- If you qualify for total or partial loan forgiveness, you’ll definitely feel better about investing.
Say you’re making great money after you graduate and can double down on your debt repayment for those student loans.
If you’re not carrying a very big balance, this could open up some choices for you.
Commit to making chunky monthly payments. You might feel pretty good about saving a little for retirement at the same time.
However, if you graduated with a huge balance, paying it off as fast as you can should be the obvious choice. You’ll be saving a ton in interest.
Once that’s done, you’re free to slay your retirement goals with a killer investment strategy.
Should You Pay Off Your Credit Cards or Invest?
With average credit card interest rates finishing 2021 above 16%, it would be scary not to tackle this debt before doing anything else.
The rate of interest is far from your only concern. Credit card debt charges compounded interest. Which means interest grows on the interest. It can get out of control fast.
And what’s worse, the Fed (the U.S. money authority) is expected to raise those interest rates possibly up to four times in 2022. Yikes!
With the extreme amount of interest that can grow on even a little bit of credit card debt — due to compounded interest — it’s rarely a good idea to do anything but get that credit paid off fast.
Benefits of Paying Off Debt
There are obvious benefits to reducing or eliminating your debt entirely. If you need encouragement, consider how these might make your life easier:
- The biggest benefit by far is getting rid of interest payments that are attached to your loans. It’s tragic to pay twice what you spent in the first place because of that growing interest.
- You’ll certainly have less financial stress in your life when debt is gone.
- There will be more money to work with each month.
- You’ll be better prepared for emergencies or unexpected expenses when that money is freed up from debt payments.
- Investing for retirement and growing your wealth will finally be within reach.
Benefits of Investing
Investing your cash also has many benefits. However, whether to invest while you’re in debt is a very individual choice. That’s why they call it “personal finance,” after all.
- Interest can work in your favor by paying you a certain rate of return when you’ve put your money into the market. Those cash gains can really add up.
- You’ll have money set aside for retirement.
- Certain investments, like dividend stocks, can provide passive income streams.
- Investing your money as early as you can and contributing regularly can potentially allow you to retire early. That’s the magic of compound interest!
Should You Invest While You Are in Debt?
There’s not really a black-and-white answer to this question. It definitely depends on each individual’s situation. Always consider consulting with a qualified financial advisor before making any final decisions.
Carrying debt can have serious consequences because interest can multiply faster than your aunt’s cats.
You’ll earn great returns just by paying off debt with high interest. You’ll be able to keep all of the money that would have disappeared into the interest hole.
For very low-interest debt, it could make sense to do a small amount of investing while doubling up as much as you can on payments to get rid of the debt altogether.
Should You Contribute to Your 401(k) or Pay Off Debt?
Often, the best course of action is eliminating what you owe before doing anything else with your money. But let’s see what the big guns say.
In a Facebook group of finance experts, I asked if it’s wise to contribute at least some money to a 401(k) account with employer matching funds (up to a certain percentage, of course) — while still carrying some debt.
I gave them a hypothetical scenario of owing $3,000 in credit card debt with 17% interest.
The finance gurus didn’t all agree on the best course of action. Far from it.
Here’s what they had to say:
- The majority said to pay off the debt first, especially since it’s a high-interest credit card.
- One emphasized that debt is like cancer and must be eliminated immediately.
- Another advised paying the debt off first because it’s a relatively small balance and then ramping up retirement investing as soon as it’s paid. (I liked this one.)
- Almost half were in favor of taking advantage of the employer match and at least putting some money into the 401(k).
- I was reminded that it’s free money and you shouldn’t leave it on the table.
- One described the matching funds as part of an employee’s compensation and stressed the importance of utilizing it as such.
- Another great point was that the invested money could begin growing right away, as opposed to waiting a number of months for the debt to be paid off.
Frequently Asked Questions
Here are the most frequently asked questions related to whether you should pay down debt or invest.
What factors should you consider to decide whether to pay off debt or invest?
- Do you have credit card debt with high compounding interest (most do)? Then pay that sucker off.
- If you have a large amount of student loan debt, you’re likely better off paying it as quickly as possible and then investing.
- Can you comfortably afford to pay extra on your debt each month and still have a bit left over to invest in a good retirement account? Consider investing.
- As you can see, there’s no one answer, and there are many factors to evaluate.
- The best thing to do is consult a financial advisor before making final decisions.
How do you decide which debts to pay down first?
Here are some general guidelines:
- Pay off those high-interest credit cards before the compound interest eats you alive.
- Pay off anything else that has an interest rate of 6% or higher. Definitely personal loans, student loans, and car loans.
- Do a thorough inventory of your finances and see where your money leaks are. Make a plan to plug all of those holes, and you’ll be a happy camper!
If you’re having trouble deciding on your financial order of operations — whether it’s choosing which debts to pay down first or when to contribute to a brokerage fund — our new course, “Financial Freedom in Uncertain Times,” can help!
The Bottom Line
Remember that your finances are unique — everyone’s are. Buckle down and find out what you owe, what the interest rates are, and whether you have any retirement savings at all. Then take that information to an advisor and figure it out together.