If you struggle with the question of whether to pay off debt first or invest your money, you’re not alone. While it’s usually best to simultaneously invest and pay off debts, that’s not always possible. When you have to choose, you have to weigh the costs and benefits to both sides and the fundamental question between benefitting now versus in the future.
Paying off debt can reduce stress, involves less risk, frees up credit you may need in the event of an emergency and better prepares you for an economic downturn. On the other hand, investing allows you to put your money to work, accumulating throughout the years with the help of compounding interest to provide you with a comfortable retirement and/or passive income.
So what should you do? Unfortunately, it’s not an easy answer. There are a variety of factors that you should take into account when deciding your course of action.
Main Factors to Consider
Consider these important factors when you’re deciding between paying off debt or investing extra cash.
The After-tax Interest Rate You’re Paying on Your Debt
The formula for determining your after-tax interest rate is interest paid minus tax savings you get back (such as on interest paid for a mortgage or student loan). Loans with a fixed interest rate lower than 6% may be worth keeping; their after-tax interest rate could be lower than what you could earn with a diversified investment portfolio. For example, someone who qualifies to deduct their interest and has a rate of 25% means that their after-tax rate on a 6% student loan would be 4.5% (6% x (1 – 25%)). If you don’t qualify for a tax deduction on the interest paid, it is likely better to prioritize paying your debts.
The Rate of Return You Expect to Earn From Your Investments
A high-yield savings account is typically a return rate of approximately 1.5% and a diversified portfolio is usually around 5-8%. Don’t forget to consider that 401(k) and Roth contributions reduce your taxable income.
First Consider the State of Your Personal Finances
Before you pay down debt or invest with your extra cash, you should ensure that you have a strong financial foundation.
Make Sure You Have Enough Savings
Financial advisors typically recommend a good amount of savings is three to six months of expenses, but at the minimum you should start with an emergency fund of at least $1,000-$2,000. This is money that is not needed for your expenses and you don’t touch month-to-month.
Make at Least the Minimum Payments on All Your Debts
Making the minimum payment will keep late fees from stacking up and keep your accounts current.
Take Advantage of Your Company’s 401(k) Match
Always start here with investing; the match is free money that you need to prioritize taking advantage of before you look at allocating resources elsewhere.
Take Into Account Other Savings Goals
If you have other goals you’re saving for, such as a down payment or a wedding, you’ll want to consider how those fit into your overall strategy.
Account for Emotional Investing
Some people like to prioritize being debt-free. If that’s the case, or if you’re more risk-averse, you shouldn’t feel obligated to weigh the numbers more heavily than your peace of mind. Even if the expected return on an investment is much higher than your interest rate, changes in the market make it impossible to guarantee that this will continue. The money you save by paying off debt (and avoiding extra interest) is guaranteed.
On the other hand, if you’re more comfortable with risk and want to ensure you have the funds to retire comfortably when you want to, take advantage of the compounding interest that comes from investing now.
And remember, you can always change your mind and re-allocate your future discretionary budget.
I’m Paying Off Debt: What Should I Prioritize?
Credit cards have a high interest rate (15-20% on average) while student debt (5-6%), car loans (5-6%), and mortgages (3-5%) are significantly lower. You should always pay the minimum on your lowest interest debts and try to pay off high-interest debt first. Debt with fixed payments and interest rates (such as mortgages, car loans and student debt) are better to carry over because you can budget for them.
I’m Investing My Extra Cash: What Should I Prioritize?
If you have a strong financial foundation (taking advantage of your company’s 401(k) match and your spouse’s match and have a fully funded Roth IRA account), consider paying off debt, then circle back and contribute the maximum allowed to your 401(k) account.
A Farm Bureau financial advisor can answer your questions and ensure that you’re making the right money moves to achieve your goals.