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 while paying off debts, that’s not always possible. When you have to choose, you have to weigh the costs and benefits to both sides.
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.
Paying Off Debt: What to Prioritize
Paying off debt reduces stress, involves less risk, frees up credit you may need in the event of an emergency and better prepares you for an economic downturn. 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.
Also consider the after-tax interest rate you are paying on debt. 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.
Investing Extra Cash: What to Prioritize
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. 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.
Also consider the rate of return you expect to earn from your investments. A high-yield savings account has a return rate of approximately 1.5% and a diversified portfolio is usually around 5-8%. And remember that 401(k) and most traditional IRA contributions reduce your taxable income.
Review Your Personal Finances
Before you pay down debt or invest your extra cash, you should ensure that you have a strong financial foundation and budget. Financial advisors typically recommend having three to six months’ worth of expenses saved up, 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.
You should also be able to make the minimum payment on all of your debts before considering investing. This will keep late fees from stacking up and keep your accounts current. And 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 financial plan.
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.
Make Informed Choices
A Farm Bureau financial advisor can answer your questions and ensure that you’re making the right money moves to achieve your goals.