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Is It Better to Pay Off Debt or Invest? How to Decide for Yourself
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Should you pay off debt or invest? Answering that question depends on a number of factors unique to your personal financial life, including how much you owe, the type of debts you have, your age and your investing options.
In some cases, the decision comes down to interest rates; you want interest working for rather than against you. But there are few, if any, cut-and-dried rules.
Here’s what to consider when you’re unsure whether you should pay off debt or invest.
- Paying off debt vs. investing
- 6 questions to ask before paying off debt or investing
- Consider a hybrid approach to paying off debt and investing
Paying off debt vs. investing
|Paying off debt vs. Investing|
|Paying off debt||
Minimize interest charges
Eliminate monthly payments and free up funds for investing or other expenses
Eliminate stress and anxiety from carrying debt
Improve your debt-to-income ratio and possibly improve your credit score
Lose out on the interest you could earn by investing those funds
Potential prepayment penalty
May miss out on tax benefits from some types of debt
Compound interest accumulates over time
Build a nest egg over time to secure your financial future
Fluctuations in the market are unpredictable
May have to make frugal choices to fund investments
May still have debt
Recognizing that you have a choice to pay off debt or invest is an important first step, said Michael Hennessy, a certified financial planner in Fort Lauderdale, Fla. You want to be intentional with your decisions and not default to either/or without careful consideration of the pros and cons of each, preferably within the framework of a comprehensive financial plan.
“We often describe these types of decisions as a whack-a-mole game,” Hennessey said. “If you only try to bop one mole and ignore the rest, you will never get a high score.”
Here are some questions to ask yourself when deciding which move to make, so you can eventually “whack” all the financial moles and secure your best financial future.
6 questions to ask before paying off debt or investing
- What is the interest rate on your debt?
- Are your debts secured or unsecured?
- Is the debt a priority?
- How much cash flow would you open up by paying off your debt?
- What’s the average return on your investments?
- Are you investing enough in your 401(k) to maximize your employer match?
1. What is the interest rate on your debt?
In general, experts agree that paying off high interest rate debt, such as credit cards, should almost always be prioritized over investing. “There are no investment options that offer a return anywhere near the rates on credit cards, and it’s critical to pay these down first,” Hennessey said.
That means paying them off in full and ahead of time to minimize interest costs. In some cases, it may even make sense to seek out lower-interest debt in the form of a personal loan to refinance your debt to lower interest rate (this assumes you qualify for an interest rate that’s lower than what you’re currently paying).
The lower the interest rates on your debts, however, the greyer the decision becomes. For mortgages and student loans may be beneficial to keep because they offer other benefits, such as potential loan forgiveness and tax deductions on top of potentially lower interest rates compared to credit cards.
2. Are your debts secured or unsecured?
Another consideration is whether your debt is secured or unsecured. Secured loans like auto loans are backed by an asset, such as your home or car; unsecured loans don’t require collateral. While secured loans can come with lower interest rates, risk-adverse borrowers may want to prioritize repaying the debt.
That’s because if you fall behind on payments on secured debt, you could lose your collateral. That could leave you in a far worse financial situation. For example, if you lose your car, you may not be able to get to work and earn a paycheck.
3. Is the debt a priority?
Determining if your debt is a priority is largely a matter of answering the previous two questions — does the debt have a high interest rate and do you stand to lose something valuable if you happen to default on it? Beyond those answers, however, there are other factors to consider, such as if your debt comes with certain benefits that makes them more worthwhile to keep.
Mortgages and federal student loans may be beneficial to keep because they offer benefits such as potential loan forgiveness and tax benefits. Consider the following:
- In 2019, you can deduct mortgage interest on the first $750,000 of indebtedness when filing your federal income taxes ($375,000 if married filing separately). For indebtedness incurred before December 16, 2017, higher limitations apply.
- With student loans, many borrowers can deduct up to $2,500 in interest paid on them (both private and government).
- The average interest rates for mortgages and students can be low compared to other forms of debt. A 30-year fixed mortgage for a $200,000 home has a 3.99% average interest rate, as of December 2019. Federal undergraduate student loans come with a 4.53% interest rate through June 2020.
Of course, that doesn’t mean you shouldn’t still work to pay off all debt, as interest, no matter how low the rate, does accumulate over time, and you don’t want to neglect debt of any kind. Also, if you don’t have an emergency savings fund that is equal to about 3 to 6 months of living expenses, then you may want to prioritize saving money over paying off debt. Without a source to cover unexpected occurrences such as major car repairs or illnesses, you could wind up in much deeper debt.
4. How much cash flow would you open up by paying off your debt?
When you pay off debt, you not only save money on interest, but you also free up the monthly payment amount you were making. Try not to consider it as extra spending money in your monthly budget though: the wisest thing you could do with freed-up funds is to funnel them toward other debt or invest it.
If you’re leaning toward prioritizing debt, you may choose to only invest money you’ve freed up by paying off debt. With this strategy, you’d increase how much you’re saving little by little.
For those who need to build an emergency fund but don’t want to avoid paying off debt, you may instead move freed-up cash into a high-interest savings account until you’ve built a healthy cash reserve. Keep in mind, though, that the interest you’d earn on that money will be less than you’d save by paying off more debt and, likely, by investing it.
5. What’s the average return on your investments?
Generally speaking, the stock market offers the best return on investment. Over the last decade from 2018, the average stock market return was 9.83%. The stock market, however, requires a patient, long-term approach to reap those types of rewards, so if you’re not in it for the long haul, then you may lose out. There are also, of course, always risks associated with the stock market and no guarantees, and some investors get nervous when it starts to drop and pull out when they shouldn’t.
Other lessy risky investments may include savings accounts, though the interest rates are typically low (1% to 2%), or individual retirement accounts (IRAs), which come with restrictions as to how the funds can be used before retirement.
6. Are you investing enough in your 401(k) to maximize your employer match?
If your employer offers a retirement savings plan, like a 401(k), make sure you’re maximizing your investment as you’re able. They offer a simple way to invest a portion of your paycheck automatically (you may even forget you’re doing it!), and accumulate interest over time.
If your employer offers matching funds — and according to the Transamerica Center for Retirement Studies, up to 85% of employers surveyed in their annual study that offer 401(k) plans do — then you should do everything in your power to contribute at least the amount they will match.
“If you focus myopically on paying down low-interest-rate debt and don’t utilize tax-advantaged saving opportunities — like 401(k)s and employer matches — you may be acting penny-wise and pound-foolish,” Hennessey said.
Consider a hybrid approach to paying off debt and investing
In many cases, you don’t have to choose between paying off debt and investing. With the exception of credit card debt, Hennessy said he encourages clients to take a more managed approach that includes paying off debt and investing.
“Absent high interest rate debt, you can create your own sliding scale that serves both interests (pun completely intended), while also keeping you committed to your plan,” Hennessey said.
Consider all aspects of your own personal financial situation when deciding whether to invest or pay off debt. You may choose to employ the help of a professional if you feel you need more guidance.