Is it Better to Pay Off Debt or Invest?
There are certain questions that come up a lot in the personal finance community, and this is one of them. In previous posts we’ve discussed tracking your expenses and challenging everything to reduce your spending. The goal is to create some breathing room between your income and your expenses.
Now once you’ve created this gap and you have some extra money, your next step is to figure out the best way to utilize it. Which brings us to our burning question: is it better to pay off debt or is it better to invest?
I’m of the opinion that there’s no “one size fits all” approach to personal finance. Everyone has different circumstances, goals, personalities, spending habits, etc. What may be the right decision for one person may not work well for someone else. Making wide-sweeping generalizations isn’t helpful, it’s more important to dig down and consider the best option for your unique situation. In this post I’ll dissect both sides of this debate and share the conclusion that we’ve been using in our own finances.
First of all, if you’re considering this question at all it means that you have some breathing room in your budget and you’re looking to use that extra money in a wise way. That’s a great place to be in! Whatever you decide, you’ll be much better off than you would have been with spending the money carelessly. Both these options will increase your net worth and improve your financial situation long-term.
Here’s a quick rundown of how I would use your extra money:
1. Establish an emergency fund.
Many financial advisors recommend building up at least $1,000 to start. We live in an area with a high cost of living so we decided to build up a bigger amount before turning our focus towards debt repayment and investing.
2. Make the minimum payments on all your debts.
3. Pay off your high interest debt.
I consider high interest debt to be 7% or more. You shouldn’t worry about investing until your high interest debt has been cleared out. Most likely this will include credit card debt or certain student loans. You can generally expect between 6-9% returns from investing, but those returns aren’t guaranteed. By paying off debt you’re guaranteed to be saving that much in interest. For example, if you pay off credit card debt with a 15% interest rate, you’re basically getting a 15% guaranteed return on your money that you would have lost to interest.
4. Don’t pass up free money.
If your company offers matching funds for your 401k, invest enough to capture the full match amount (usually around 3-6%).
After these steps, if you still have money remaining, consider your situation. How much remaining debt do you have? What are the interest rates of those debts? How far away are you from retirement? What are your longterm goals? Once you’ve figured out some of these answers, direct your extra funds accordingly.
For our situation, last time I shared how we’ve paid off more than half of our $27,000 of student loan debt in the last 10 months. We’ve made debt repayment the biggest focus in our budget. The majority of the debt that we paid off had an interest rate of 6.55%, while the remaining $12,000 debt is around 3-4% interest.
We’ve also each been investing 10% of our paychecks into our 401k’s while paying down our debt. We decided to do this for a few reasons. First, it lets us capture the full match that each of our companies offer for our 401k’s. Secondly, it lets us start at a young age so that compound interest can begin to work its magic. Additionally, it helps us establish the positive habit of making saving for retirement one of our biggest focuses.
By examining our situation closely I have realized that carrying debt takes a psychological toll on me, but it’s also important to me to know that every single month our retirement savings is growing.
Mathematically, now that our higher interest rate debt has been paid off, it might make sense to direct all of our extra funds towards retirement savings. There’s no guarantee on what our returns could be, but it would likely be higher than the 3-4% interest rate that we have on our remaining student loan debt. This could help us achieve the highest level of net worth long-term. However, this would also involve the risk and psychological repercussions of carrying debt for a much longer amount of time.
To conclude, we’ve decided to continue to direct 10% of our paychecks into our 401ks, but all the rest of our extra funds are going straight towards debt repayment. Personal finance is about more than math, there are a lot of emotions to consider when it comes to money. Becoming debt free is our biggest priority, even if it means potentially missing out some larger investment returns. We’re looking forward to the added freedom and flexibility we’ll soon have. Once we achieve debt freedom, increasing our retirement contributions will be the next step.
Now it’s your turn to weigh in, do you think it’s better to use your extra money towards accelerated debt repayment, or investing?