Which Should You Do First? Pay Off Debt or Invest?
Nerdwallet conducted a survey that found the average U.S. household that held debt had approximately $16,000 in credit card debt and $131,000 in total debt.
When you isolate student loan debt, the average U.S. household with student loan debt has an average of about $48,000 of student loan debt. The total student loan debt for all U.S. consumers combined? A staggering $1.23 trillion.
You get the point: debt plays a huge part in personal finance for most Americans.
More likely than not, you have some type of debt. Whether it’s credit card debt, student loan debt, or a mortgage, most people in the United States have to plan their finances around their debt.
Paying off debt is clearly a good thing to do, but it’s not the only “good” thing we can do for our finances. Investing is also a good thing to take part in, but at what point do you slow down paying off debt to free up some money to invest?
There are many finance experts who say that you should pay off debt as quickly as possible. Probably the most famous of the anti-debt finance experts is Dave Ramsey. Dave Ramsey has built a brand around being an advocate of paying off debt as soon as possible.
Despite Dave Ramsey’s advocacy of paying off debt quickly, he still recognizes the need to invest. Take mortgage debt as an example. Dave recommends that you “first invest 15% of your income for retirement before you work toward paying off your mortgage.”
The fact that even Dave Ramsey recognizes the need to invest even while in debt shows just how important investing is. But what’s the underlying reason for this? Compound Interest.
You probably have heard the term compound interest at some point in your life, but what does it really mean?
To illustrate how compound interest works, let’s use an example from my book Hustle Away Debt.
If you deposit $1,000 a month every month for ten years into an investment account that has an 8% rate of return (compounded monthly), you would have $184,000 at the end of the ten years. Meaning, you would deposit $120,000 over that time frame and gain $64,000 in interest.
On the other hand, let’s say you deposit $100 a month every month for twenty-five years into an investment account that has the same rate of return. At the end of the twenty-five years you would have deposited just $30,000 (or a whopping $90,000 less than our previous example), but you would have earned approximately the same amount from interest ($65,000 in this case).
As you can see from this example, investing sooner rather than later can have a huge impact on your finances.
You may be wondering with the power of compound interest why wouldn’t you want to prioritize investing over everything else?
Simple: not all debt is equal.
We are all familiar with the different types of debt: student loans, personal loans, credit cards, etc. The biggest thing that differentiates debt is interest rates. And boy, what a difference it can make.
Take credit card debt. If you don’t pay off your credit card in full each month you will get charged interest, which can reach 20% or higher depending on the card you have. On the flip side some unsecured personal loans can be as low as 1.99%.
That’s a huge difference!
Another good example is mortgage debt. Mortgage debt is currently available at very low interest rates. I purchased a home three years ago and have a 3.25% interest rate. If you purchased a home today you’d get around 4%, which means mortgages have been a very “cheap” form of debt for the past few years, and will likely continue to be.
When you have low interest rates it can make sense to pay the minimum and invest the difference. Paula Pant, founder of the personal finance website Afford Anything, says "putting your money to its highest and best use might involve making only your minimum mortgage payment so you can invest the rest in higher-yielding opportunities."
This can apply to any low-interest debt. For example, I took out a loan for both my car and my wife’s car. Many experts would advise against this, but I did it because we were able to secure a five-year loan with a 2.25% interest rate. I always pay the minimum and use leftover cash to invest. Over time this will be a profitable decision since it’s unlikely that the market will return less than 2.25%. Historically the market has returned 9%.
As with most personal finance topics, it’s important for people to consider everything in the context of their own unique situation. Be sure to take the following things into consideration when deciding whether to pay off your debt or invest:
- Free money from an employer - If your employer offers a 401k match up to a certain percent, make sure you are contributing at least up to that percent. If you aren’t contributing up to the match percent, you are leaving free money on the table!For example, if your employer matches dollar-for-dollar up to 6% of what you are contributing, you are literally making an immediate 100% return on the first 6% you contribute. Every dollar you put in you are given a “free” dollar—don’t miss out on this!
- Interest rates - If you have credit card debt with a high interest rate make sure you prioritize paying it off before you start investing (except in the “free money” scenario described above). Other interest rates aren’t as clear. If you have 6.5% interest rates on student loans, should you really invest instead of pay them off? Despite the market returning an average of 9% over time, many would say the satisfaction of not having this debt hanging over their head is worth more than any potential investment gain.
- Your personal preferences - Some people are uncomfortable with any debt, including a mortgage or other low-interest debt. If you fall into this category you may find yourself unconvinced by interest rates or any other factors that tell you to invest rather than pay off debt. You aren’t alone, and you should factor in the psychological impact of having debt when making a decision to invest or pay down debt.
As you can see there is no one-size-fits-all answer for the debt versus invest question. With that being said, hopefully looking at some key points like interest rate and your personal preferences about debt will help you make the right choice for your situation.
Disclosure: I am not a financial advisor and this post is for purely informational purposes. Always discuss financial decisions with a certified financial planner prior to implementing.