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Should You Pay Off Debt or Invest?

Should You Pay Off Debt or Invest?

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Should you pay off debt or invest? The answer really depends on your specific situation, but it is a question worth exploring in detail since so many people go through this decision-making process at one time or another. The first step to answering this question is to understand the debts that you owe.

Pay Off Debt versus Investing

Pay Off Your Debt First

Paying off debt has many benefits. It reduces your stress, strengthens your relationship, increases your credit score, improves your cash flow, and gives you more financial control. Although ignoring investing entirely is seldomly the most optimal solution, you should focus on pay off your debt exclusively if you meet one of the following conditions:

  1. You are accumulating more debt. If the amount you owe is increasing each month, you have to focus on your improving your cash flow. When you are accumulating debt, you are spending more than you earn. To get you moving in the right direction, you need to make adjustments so that you can earn more than you spend. Take a look at our 12 Steps to Financial Success Plan and focus on steps #1 to #3.
  2. You owe a tax debt or a tax lien. You don’t want to owe the IRS or your state government any money, because the consequences of tax debt are quite severe (see H&R Block’s article: The Top 10 Consequences of Tax Debt). These debts should always be your top priority to pay down.
  3. You owe payday loan. A payday loan is very expensive, and the fees cycle is very frequent. When you owe a payday loan, it is an indication of a deeper financial issue that needs to be resolved before you should even consider investing.
  4. You are not a proficient investor. It takes a certain amount of knowledge and proficiency to make investing worthwhile. If you don’t know anything about investing, focus on paying off your debt, and take the time to learn how to invest your money wisely.

If you meet any of these conditions above, take comfort in knowing that improving your cash flow and paying down debt is the best option.

Investing vs. Pay Off Your Debt

If the list above doesn’t apply to you, then investing some money before paying off your debt might be a better choice. In the discussion below, we will assume that

  • You are a proficient investor that can get close to the average annual return of 9%,
  • You are repaying all debt on time, and
  • Your total debt is going down each month.

Here is what I think is the best order for paying down debt vs. investing.

1. INVEST: 401(k) Employer’s Match

If your employer offers a 401(k) plan and they provide matching contributions, you are almost always better off contributing to your 401(k) to get the match.

401(k) matching is the only time you have an opportunity to get free money. This is an instant 50%-100% return on investment, and you get a tax deduction on your contributions as well. Let’s assume you have $250 extra a month to put toward credit card debt at 20% interest rate or 401(k); this is how the math works out.

Paying Credit Card at 20% 401(k) Match
$250 x 20% saves you $50 in after-tax money. $250 invested results in a $125 match at 50 cents for a dollar matching rate. You will eventually have to pay income taxes on the $125, so the true after-tax value is about $90 (based on ~27% tax rate)

The $250 contribution is also tax-deductible. At 22% federal and 5% state, you are saving $67.50 in after-tax money.

Total Value = $50 Total Value = $157.50

As you can see, a 401(k) contribution with matching should always take priority.

TIP: If you don’t have at least $1,000 in your emergency fund after you max out the match, set up your mini-emergency fund now. Take a look at our Step #4: Set Up a $1,000 Mini Emergency Fund.

2. PAY OFF DEBT: Credit Cards & Double-Digit Interest Rate Debts

The average credit card interest rate is about 20%, and the average cash advance interest rate is about 24%. The average rate of return for the stock market is about 9%. It is safe to say that paying down your high-interest debts (i.e., anything that is 10% or higher) should be your next priority.

Paying down debt has several advantages:

Paying Down Debt Investing
  • Risk-free
  • Guaranteed saving
  • Each dollar saved is equal to about $1.55 you have to earn
  • Works well in any economic or market condition
  • Reduce your monthly expense with each debt you paid off
  • Better than investing if your time horizon is short
  • Risk of loss. You could lose your entire investment
  • Return is not guaranteed
  • You have to pay taxes on your gains, interest, and dividend
  • Doesn’t work as well in a bad economy or bear market

Although you can argue that contributing to retirement savings where you’re getting about 27% tax savings is mathematically better than paying down credit card debt in some situations, I feel strongly enough about credit card debt to say this: if you cannot pay off your credit cards in full each month, you should not be thinking about investing. The only exception to this rule of thumb is contributing to 401(k) to get the employer’s match.

Don’t forget to negotiate down your interest rates, use balance transfers, or refinance your debt.

3. INVEST: Retirement Savings Contributions

As mentioned before, saving for retirement in tax-deferred and tax-free accounts is very rewarding. Even without the match, contribution to your 401(k) and a Traditional IRA is more financially rewarding than paying down debt even at a 20% interest rate due to the tax savings and potential for growth.

If your debt is decreasing each month and all the expensive ones are paid off, then go ahead and try to max out your retirement accounts. You can contribute up to $19,000 to your 401(k) and $6,000 to your IRA.

Since Roth 401(k) and Roth IRA are even better than their traditional counterparts, you should contribute to these accounts first even without the benefit of tax deduction. The tax-free growth and tax-free withdrawal will more than compensate for this small loss.

Lastly, make sure you invest your contributions. At the minimum, you should invest your money in an S&P 500 Index Fund, a US Broad Market Fund, or a Target Date Fund.

4. PAY OFF DEBT: Debt with 6.5% or Higher Interest Rate

The next priority is to pay down any debt with 6.5% or higher interest rates before doing any more investing.

Here is how we arrive at the 6.5% figure.

Most people pay about 20% taxes on their investment gains (i.e., 15% long-term capital gains tax to the IRS and about 5% to the State). This means that a 9% gain is reduced to 7.2% after taxes. To account for the additional risk, transaction fees, and investment expenses, we reduced 7.2% down to 6.5%.

Depending on your personal investing skill, taxes, and risk tolerance level, you could lower the 6.5% figure to 6% or even 5% to be more conservative. Although I am very comfortable with investing, my personal cut off point is at a 5% interest rate.

5. Invest in Taxable Account vs. Paying Off Debt with Interest Rate Between 4% to 6.5%

If you made it this far, congratulations! This means you have positive cash flow, you are reducing your debt total each month, you have paid off your high interest rate debts, and you contributed the maximum to your retirement accounts.

That is quite a lot of accomplishments, and you are doing a fantastic job of managing your finance!

At this point, it comes down to your personal preference whether you want to pay down debt in the 4% to 6.5% range or use that money to invest in a taxable account.

The most common debts in this range are your student loans and auto loans. Whichever way you choose, your decision is financially beneficial, so pick the route that inspires you the most and just go with it.

6. Low-Interest Debt or Debt with Tax Benefits

Last but not least are debts that charge lower than 4% interest, or debt with tax benefits like your home mortgage or home equity loan.

Personally, I know I can grow my net worth faster by investing, so I never pay down these debts any faster than I have to. I just pay the minimum each month and invest my money instead.

Bottom Line

There are certain situations where it is clearly better to pay off debt and other situations where it is clearly better to invest. Hopefully, this guide helps walk you through the steps and decide between paying off debt vs. investing easier.

 

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Should You Pay Off Debt or Invest?

by Pinyo Bhulipongsanon time to read: 6 min
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