Choosing between paying down debt or investing is a balancing act. I’m sure you’ve heard something like this before: “Compare the interest rate on your debt with an expected return from your investments and put your money towards the option with a higher rate.”
This money advice makes sense in theory, but there are more moving parts you should consider in practice. Besides, nobody can predict what kind of return your investments are going to yield.
What to do first
Before you start debating whether you should pay down debt or invest, please make sure you check off the following items on your financial wellness list.
Make minimum debt payments
It goes without saying that you should be making minimum monthly payments on all of your debts. You want to preserve your credit score, avoid late fees and increases in APRs.
Take advantage of free retirement money
Nobody likes to leave free money on the table. So, if your employer has a 401k match program, take advantage of it. It’s free money for you! Contact your human resources department and find out all the details.
Here is an excellent post on the 401k match if you would like to learn more.
Even though offering a 401k match is very common, some employers do not do that. If that’s the case for you or you are self-employed, skip to the next step.
Work on your emergency fund
Emergencies can happen to anyone, so it’s essential to create a financial safety net to protect yourself from accumulating more debt.
At first, focus all your energy on saving at least one month’s worth of your basic living expenses. Once you have that accomplished, you can divert some of the savings towards paying your highest interest debt while still working on bumping up your emergency fund to at least three months’ worth of living expenses (or higher, whatever makes you feel secure).
Tackle high-interest debt
If you have any debt with interest rates higher than 10%, create a thorough plan on paying it off and stick to it. You cannot build any long-term wealth if you’re paying +10% in interest payments.
Dave Ramsey is famous for helping people get out of debt, so if you’re looking for debt repayment strategies, check out this article.
Decision time: pay down debt or invest?
Your emergency fund is in the bank (put it in a savings account, don’t invest it!). Your highest-interest debt (above 10%) is taken care of. Congratulations! You’re doing fantastic!
Now it’s time to decide whether you should pay down more debt or invest your unmatched retirement dollars.
The key here is your debt interest rate.
Generally, if your lender is charging you more than 5%-7%, keep paying it off and then start investing.
If, however, you’re paying less than 5% -7% on your debt, it likely makes more sense to invest.
An essential factor to consider is how aggressive you are in your asset allocation. For example, if your asset allocation is geared more towards stocks, you may choose to invest rather than pay down debt at 7%.
If, however, your asset mix is more conservative, you may choose to invest only if your debt interest rate is 5% or below.
For a balanced portfolio with 50% in stocks and 50% in bonds, your benchmark interest rate could be around 6%. If your debt is costing you more than 6%, pay it off. Otherwise, invest.
The Bigger Picture
Deciding between paying off debt or investing depends on several factors, such as the interest rate you are paying on your debt and your risk appetite when it comes to investing.
My hope for you is that instead of overthinking what you should do, you will simply take action. Remember, any money you are putting toward paying off debt or investing is a step in the right direction.