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.