Are you dealing with debt? Then, you must wonder if you should pay off your debt before investing money. Investing early is always a good thing to do. It allows you to grow your money and earn returns through compound interest. However, paying off high-interest debt will help you reduce your debt. It can provide a guaranteed “return” equal to the interest rate.
So, what is the most brilliant move you should make? There’s no one-size-fits-all answer. The right answer will depend on your specific situation. This guide will help you figure out the right solution based on your needs.
The Case for Paying Off Debt
Paying down debt, especially high-interest debt like credit cards or personal loans, has some compelling benefits. Let’s explore these benefits in detail.
Reduces Total Interest Paid
If you are in debt, you must make interest payments for your principal amount. If you can pay off debts faster, you can reduce the total interest you pay throughout the loan term. This will free up more cash, which you can use for investments.
Lowers Risk
Having debt would increase the overall risk that you have in your finances. Market downturns or income disruptions can make it hard for you to reach your debt obligations. Things become prominent when you are over-leveraged. But if you can reduce debt, you can reduce this risk exposure.
Creates Flexibility
Debt payments are fixed expenses that limit flexibility in your budget. By paying off debts, you free up disposable income to save, invest, or spend at your discretion. This flexibility enables you to respond better to unexpected expenses, too. It can provide you with peace of mind.
Improves Cash Flow
You will have to deal with lower monthly payments when you have less debt. Reducing these fixed expenses could improve your overall cash flow. As a result, you will have more money to allocate towards your savings or investment goals every month.
Offers Peace of Mind
Finally, becoming debt-free provides immense psychological benefits. It removes the stress of fixed payments hanging over your head each month, and the peace of mind of zero debt is powerful.
The Case for Investing
Now you know the benefits you can experience by paying off debt. Similarly, there are benefits that you can get by investing money as well. Let’s take a look at a few such benefits.
Benefits from Compound Growth
Investing allows you to grow your money over decades through the power of compounding. Even small upfront investments can snowball into more outstanding sums over years of disciplined saving.
Earns Higher Returns
When markets perform well over the long run, investment returns exceed interest rates on many types of consumer debt. This means your money can grow faster through investing compared to eliminating lower-cost debts.
Enables Important Goals
Investing provides funds to achieve significant goals like retirement, college savings, or a home down payment. Paying off less expensive debt does little to help you progress toward these long-term goals.
Offers Tax Advantages
Investment accounts like 401(k)s and IRAs provide valuable tax reductions or deferral benefits. This allows your investments to grow tax-free or with deferred taxes. Paying down debt does not offer these advantages.
Where to Draw the Line
In light of these tradeoffs, a good rule of thumb is to determine whether your debts have higher or lower interest rates than you could reasonably expect to earn through investing.
As a benchmark, broad stock market index funds have historically earned about 7% annually after inflation. Ifppose you have debt with interest rates above 7-10%. In that case, it usually makes sense to prioritize repaying those high-cost obligations first before investing. This allows you to reduce total interest costs and risk.
On the other hand, lower-cost debts like mortgages (3-4%), federal student loans (2-7%), and auto loans (4-7%) often have rates comparable or lower than stock market returns. In this case, most financial experts recommend prioritizing investments over prepaying low-interest debt. This enables your money to grow faster in the long term.
Tactical Tips to Follow
Within this general framework, several tactical tips can help guide your decision-making:
• Take advantage of employer-sponsored plans. If your employer offers a matched retirement savings plan like a 401(k), invest enough to get the full match before directing extra funds towards debt. This equals a 100% immediate return that outweighs interest costs on low-rate debt.
• Build emergency savings. Before aggressively paying down debt or investing large sums, save 3-6 months’ living expenses in an emergency fund. This provides a buffer to avoid further high-interest debt during financial stress.
• Make minimum payments on all accounts first. Be sure to at least make the minimum monthly payment on all debts before directing discretionary money toward a specific account. This prevents late fees or credit damage.
• Consider the psychological benefits. While financially sub-optimal, some people receive enough emotional reward from quickly eliminating a troublesome debt to warrant making extra payments there first. Know yourself.
• Re-evaluate annually. Review your finances yearly to determine if income, debts, or market performance changes favor adjusting your prioritization. Be strategic and remain flexible.
Following an Integrated Approach
The best approach often combines debt repayment and disciplined investing as dual pillars of a strong financial plan.
You can make steady progress towards all your goals by methodically chipping away at lower-cost debts while consistently funding retirement and savings accounts. The key is allocating disposable income in a balanced manner aligned with your risk tolerance and cash flow.
There’s no definitively superior order – only tradeoffs to evaluate based on your specific situation. With a strategic outlook, you can craft an integrated plan to optimize debt repayment while still investing for the future. Committing to both pillars is smarter than choosing just one.
