Is It Better to Pay Off Debt or Invest?
Making the decision to pay off debt vs. investing comes down to whether you'll get a greater return by earning interest or by reducing interest paid.
There's no doubt that investing is important. Whether your goal is to build a retirement fund or to hedge your money against inflation, having your money stashed away in income-generating accounts carries the potential to increase your financial worth even beyond a high-yield savings account. But, if you're carrying debt, you may wonder whether you should focus on paying down outstanding balances before you start investing.
There are generally two options, and no one-size-fits-all answer.
You Can Do Both
One approach is to find a balance between paying off debt and investing, splitting your available money between the two. Investing while you're paying off debt allows you to benefit from compound interest and time in the market. The longer you have money invested, the more time you have for your funds to grow. And if your employer matches 401(k) contributions, you could be leaving money on the table should you choose to delay contributions.
You can still make progress on paying off debt while also investing, but keep in mind it can take a little longer to become fully debt free. Looking for other areas to cut spending frees up cash that you can put towards paying down debt faster while you work on building your nest egg. You might also consider investing only enough to receive your employer's 401(k) match, then put the rest of your money towards eliminating debt.
Or You Can Pay Off Debt First
The other option is to pause investing while you pay down your debt. This is particularly beneficial if you have high interest rate credit card debt, predatory debt like payday loans, or past due obligations. For most people, it makes better financial sense to prioritize these over investing.
With high interest rate debt, the interest you pay on your balance offsets the returns on funds you have invested. For example, paying interest on a credit card balance with an 18% APR will cost you more annually than the interest you earn on a 10% investment.
If you're only carrying low interest rate debt like mortgage and student loan debt, you have more flexibility. These interest rates are likely lower than the average investment returns, which means you're not throwing away money on interest if you decide to invest and pay off debt simultaneously.
Deciding whether to invest or pay off debt isn't just about the amount of interest you pay or earn. High credit card balances can affect your FICO® Scores, which can make it more expensive to borrow money since available interest rates are usually affected by credit rating.
The drawback of waiting to invest is that you miss out on time in the market if it takes you several years to completely pay off your debt.
How to Pay Off Debt Faster
Consider pausing your retirement contributions and other regular investments to aggressively pay off your high interest rate debt, and then resume contributions once you are debt free. Any money you currently have invested may continue to benefit from the market's growth potential.
When it comes to specific debt repayment strategies, the debt avalanche method—where you pay off highest interest rate debts first—allows you to pay off debt faster and save the most money on interest.
Making a Final Decision
Ultimately, it depends on your personal preferences. It may help to calculate the potential returns in each scenario so you know the impact of each option. Once you understand the risks and rewards, you're empowered to make your own decision.
With either strategy, be sure you should have an emergency fund that you can fall back on if you have unexpected expenses, or if you lose your income. This allows you to take care of your expenses without getting into more debt or having to access any of your existing investment accounts.
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