Should you pay off debt or invest the money instead?
By: Ian Johnson
Tags: Debt

Should you pay off debt or invest the money instead?

That’s a common question asked around American kitchen tables on a regular basis, and it’s a question that really has no perfect answer.

The only common answer to the question of debt versus investing depends on your own personal financial situation and your short- and long-term financial goals. Without knowing a financial consumer’s own unique cash flow and debt situation, it’s hard to say if debt or investing should take priority over the other.

What financial experts do know is that there are more specific household budget scenarios where paying off debt makes more sense than investing — and vice-versa.

So, to provide some much-needed clarity to a historically thorny — and pervasive — household finance questions, let’s examine where paying down debt is preferable to investing and where investing is preferable to paying off debt.

The Case for Paying Down Debt First

Overall, becoming largely debt-free is a liberating prospect even if your investment portfolio is gathering cobwebs in the process.

By paying down debt, you’ll sleep better, have less stress, build a better credit score, and save money on future credit and loan needs, as a more robust credit score will lead to lower interest rates and better loan and credit conditions.

Those are highly desirable outcomes for any consumer and they give ample weight to the argument that paying off debt should come first.

Of course, some scenarios are more dire than others and you’ll really need to focus on debt over investing in the following scenarios:

You Are Paying Off Debt With High Interest Attached

Paying off debt can really come down to the interest you’re paying on that debt.

For example, if you’re paying off $5,000 in credit card debt with an interest rate of 25% (that’s not uncommon on credit card debt), you’ll want to get that piece of debt off your ledger before you ever consider investing the money.

Even if you pay $250 a month, and that’s a healthy sum of a middle-class earner’s monthly income, it would still take you 27 months to pay down the total $5,000 debt. In the meantime, you’re paying an additional $1,535 in total interest on the card.

Now, you may or may not do better by investing in the stock market over that same period. What’s for certain is that you’ll be taxed on the investment return if you want to cash out and you’ll likely still face an even higher credit debt after the five years are up.

The Verdict

Pay down the high-interest credit card first. You’ll eliminate the 25% interest payment penalty on your card and you’ll improve your credit health in the process.

That’s likely a better deal than investing the money instead, especially if you either eliminate or severely curb the use of that high-interest credit card altogether.

You Are Paying Off High Student Loan Debt

Let’s face it, shouldering the burden of soaring student loan debt is as much an emotional issue as it is a financial issue.

There are few investments that can alleviate the stress and strain of having high student loan debt. That’s especially the case with student loan debt of 6% or higher, which can really eat into the household budget as you’re paying the debt down.

Luckily, there’s a good “tried and true” formula for deciding to pay off student loan debt or investing the money — and once again largely dependent on your student loan’s interest rate.

If your loan interest rate is 6% or higher, you should focus your attention on paying down your student loan debt as fast as possible.

That’s because most investment vehicles — even high-returning stocks — usually only average 6% in returns after taxes. Putting money into stocks and funds at a 6% return rate when you have a student loan debt of $25,000 or $50,000 at a loan interest rate of 6% or higher is just bad business, financially and emotionally.

The Verdict

If your student loan rate is 6% or higher, pay down the loan first, and do so as fast as you can.

It’s a tough call given the fact that you want to start saving for retirement as soon as you’re in the workforce, but a high-interest rate student loan will always be in your way.

Better to pay down the high-interest rate student loan debt first and focus on retirement savings later, if your household budget is currently tight.

You View a Home Mortgage as an Investment Preferably Over Paying Debt

No, it’s not — especially for younger consumers burdened with high credit card and student loan debt.

At first glance, a home purchase may well result in a big profit. There is no guarantee that’s going to happen in the first place (ask anyone who bought a home in 2005-to-2007, just before the Great Recession hit.)

Also, many home buyers tend to overpay and buy a home they really can’t afford, which bites into both the household budget and any future returns if and when you sell the home.

Those same homeowners may suffer a layoff or illness or injury, and may not able to keep up with their home mortgage payments, putting them further behind on their total debts.

The Verdict

Pay down your debts before you buy a home. You’ll have learned a great lesson about debt by having to pay it back, which should lead to smarter home buying decisions when you do pay off all that debt.

The money you’ll save in that scenario can easily be put to use in a 401(k) fund or into the financial markets directly later on, under the guidance of a good financial planning professional.

The Case for Investing Over Debt

Here, the decision is more clear cut.

Basically, you want to choose investing over debt if the likely outcome is having the investment pay out so much in returns, you can’t afford to pass up the opportunity.

This can happen in several scenarios.

For example, let’s say your company offers a 6% match on your annual 401(k) plan contribution. That means the employer will match up to 6% of any contributions you make to a 401(k) plan, based on your annual income.

That means if you earn $50,000 annually and you invest 6% of that amount ($3,000) into your 401(k) plan, your employer will match your contribution of $3,000, giving you a total amount of $6,000 contributed to your retirement fund that year.

That’s free money and you should never turn free money down.

Consequently, if you run into a 401(k) scenario where your company offers you a big company matching contribution, find the money to invest in your retirement, and grab the free matching contribution amount as a huge bonus.

Or, let’s say that your company offers you access to a potentially profitable profit-sharing or stock options program. If so, take the deal and put off debt for a while.

While not every company profit-sharing plan or stock option deal will lead to a big financial payout, many do.

By getting in on the ground floor and earning a discount on stock options, especially, you’re getting that rare opportunity to pop your household debt on the back burner and go for the investment — and the big rates on return — instead.

The Takeaway on Debt vs. Investing

The last word on debt versus investing?

By and large, financial experts advise consumers to avoid debt in the first place by living within your means. In numerical terms, that means keeping your monthly debt-to-income ratio (i.e., the amount of money you owe against the amount of money you earn) to no more than 30% of your pre-tax household income.

In other words, if your total household debt obligations each month total $2,000, and you earn $48,000 annually (or $4,000 a month before taxes), you’re on your way to a big debt problem and likely won’t have the cash to investment substantially anyway.

Stop that excessive debt behavior in its tracks by creating and sticking to a household budget, put your credit cards away, and keep a sharp eye on the money coming in and the money going out of your budget every month.

Get a good digital family budget planning tool like Mint, Albert or Clarity Money and put it to good use every week, and learn how to live within your new household budget.

Do that and your chances are good that you have can have the best of both worlds — you can invest a little bit of money each month and still have enough money to chop down your personal debt, as long as you have a good job and live by prudent personal financial habits.

That’s easier said than done, but it does spare you from having to choose between two necessary personal financial obligations — paying down debt or growing your money through investing.