This is the age-old question when it comes to personal finance. And as most questions go in personal finance, the answer is – it depends.
It depends on the kind of debt you have and the kind of investments, but it also depends on your age, your disposable income, and your risk aversion.
Ultimately, you want to compare the after-tax cost of your debt to the after-tax return on investment. If you’re paying 13% interest on your debt (as is often the case with credit card debt), that’s a guaranteed 13% return when you pay off your debt. You won’t find that with any investment out there.
However, if you’re only paying 3% interest after taxes (as is sometimes the case with a mortgage), you could easily find investments with a greater return.
So, there are some questions you’re going to have to ask yourself before you can decide whether to focus on paying down debt or investing.
How much debt do you have?
If you have unreasonable amounts of debt, then it might make sense to focus on paying some of it off, regardless of what your interest rate is. It’s recommended that your debt to income ratio (not including mortgage debt) be less than 20%. Divide your monthly debt (less your mortgage) by your monthly income. If it exceeds 20%, focus on getting it below that number.
Excessive amounts of debt can also have a negative effect on your credit score. One of the biggest factors is your debt-to-credit ratio – that is, the overall amount of debt you carry divided by the overall amount of credit you have access to. This number should never exceed 33%. If it does, focus on lowering it before investing.
Consider your age
Investing works best in the long run. Returns are higher and risk is minimized.
If you have a lot of time left before you retire, investments have huge return potential, thanks to compounding interest. However, if you’ve only got 5 or 10 years left before retirement, your investments returns won’t be as impressive, and they will be more risky.
The younger you are, the more sense it makes to invest aggressively. The closer you get to retirement, the more sense it makes to focus on paying off debt.
Emergency savings fund
It’s important to have a cash cushion in case something goes wrong. If your bank account gets drained each month after you pay the bills, you should consider building up an emergency savings fund before you start investing OR paying off debt.
Imagine you aggressively pay off most of your student loans, but you have no emergency savings fund. Then you lose your job, and you can’t afford to make your monthly minimum payments anymore, even though you only have one year left until you’re debt free. Imagine you pay off your debt aggressively and lose your job, and you don’t have an emergency savings to cover your bills.
What do you do? Many people would be forced to take on a personal loan or credit card debt with extremely high interest rates. In the end, it would have been smarter to build a savings cushion instead of paying off debt.
Ideally, you should have 6 months of income saved in an emergency savings fund. However, if you are dealing with very high-interest debt, such as credit card bills, it might be wise to cut that down to 2 or 3 months income saved up until you’ve paid off your commercial debt.
Investing for retirement
Even if you’re paying off credit card debt, you can still start investing toward retirement. If your employer offers matching contributions to your 401k, you should absolutely take advantage of that. It’s free money, after all.
Contribute what you can until your credit card debt is paid off. Once your high-interest debt (more than 7%) is paid off, contribute the maximum that your employer will match.
Finally, once your after-tax interest rate is below 5%, you can start branching out into other forms of investing for retirement. Once it’s below 4%, invest away! Inflation will minimize the cost of your debt at that point, and the long-term return on most investments will be much more than the cost of your debt.
Paying Off a Mortgage Before Investing: No
Mortgage debt is not bad debt. It’s one of the most normal, low-interest forms of debt you can have.
For example, let’s say you have a fixed 4% interest rate on your mortgage. If you’re in the 35% tax bracket and receive a tax deduction on that mortgage interest, your after-tax cost of debt is 2.6%.
Most investments will give you a greater return. It’s common to see after-tax returns of 6.5%. Even after adjusting for inflation, which we’ll say is 2% per year, that’s still a 4.5% return. This is still a much greater return than the return on paying off your mortgage.
Paying Off a Credit Card Before Investing: Yes
Consumer debt is the worst kind of debt to have. It can bring down your credit score if you have too much, and the interest rates will kill your finances. You should focus on paying off your credit card before investing.
If your interest rate is above 10%, consider consolidating or refinancing your debt with a low-interest personal loan or consolidating your debt with a 0% APR credit card. This will help you pay down your debt faster without giving up so much money in interest.
Paying Off Student Loans Before Investing: Maybe
Of course, meeting monthly minimum payments is a first priority. You never want to miss your student loan payments. If you still have leftover income, make sure you have an emergency fund and contribute the maximum to employer matching programs.
If you get to the point where your interest rate is as low as 4% or 5%, it might be time to start investing. Let’s look at an example.
If you have $40,000 in student debt and a 4% interest rate (this is lower than average) on a 10-year loan term, and you have $750 in disposable income each month after making your minimum payments, you might be tempted to put the rest of it toward paying off your student loans. If you did that, your repayment period would go from 10 years to 5 years. Sounds great!
However, you would actually lose about $39,000. If you had instead invested all of that disposable income at a 7% rate of return, after 40 years, you’d have an additional $39,000 saved up just from investing that extra $750/month for five years.
Of course, if your interest rate is 6%-7%, it might make more sense to focus on paying off your loans. That’s a guaranteed return of 6-7%, whereas investments only offer a potential return of 6-7%, and that’s in the long run. There is always risk with investments, whereas paying off debt is risk-free.