Should I invest or pay down debt? I have had this question come in through a few emails and it always comes up in personal finance conversations.
Before we get to far into the question itself, I want to highlight that simply asking this question shows that you are on the right path. If you aren’t asking this question you are likely adding to your debt while simultaneously not investing. Even though the personal finance community is split on this question, we all agree that doing neither is 100% wrong.
What about savings? I purposefully chose the word invest over save for this title. Excluding our Emergency Fund, saving and investing are the same word in our house. We aren’t stockpiling cash at the moment so all of our savings are invested.
Read on if you want to see how I breakdown the “Invest or pay down debt” question.
Benefits of Paying Down Debt
- Emergency Planning – Less debt = More secure. As you drop your debt levels building your Emergency Fund and creating your Emergency Plan become a lot easier. The more mandatory payments you can chop off the less you need in your fund.
- Interest – An obvious benefit is you wont be wasting more money on interest payments. Use an interest calculator to figure out how much interest you will pay over time (google “how much interest will I pay” if you aren’t familiar with these calculators). You can see the savings by paying extra by increasing the monthly payment.
- Freedom – Since we still have a decent amount of debt, I can’t fully speak to how freeing being debt free is. But I know of other personal finance bloggers that have celebrated this milestone and will never go back to having debt.
Benefits of Investing
- Financial Independence – Investing is the clearest way to Financial Independence. The younger you start, the longer your stockpile can grow. It is incredibly difficult (if not impossible) for the average person to reach F.I. without investing.
- Money works for you – Putting your money to work for you is the biggest benefit of investing. Harnessing the power of compound interest is a must.
- Freedom- Yep, this one goes under both. Being Debt free is freedom from lenders. Investing and building a net worth is freedom from work.
- Passive Income – Depending how you deploy your capital, you could create passive income channels that make you even less dependent on a full time job.
How to break down your situation
When deciding to invest or pay down debt consider these factors:
Interest Rates – One of the biggest factors you need to take into account is your interest rate. Credit card debt is a killer, most interest rates are above 15%. Anything over 5% should be targeted for debt payoff at an accelerated rate.
Years to retirement – This is a tricky one because both of these options have distinct benefits as you approach retirement. The longer your investments work for you, the more cash you will have at retirement. If you are 100% debt free you need a lot less money when you are retired (think no home payments).
Emergency Fund – Before you get to far down the Invest or Pay of Debt path, make sure you have an Emergency Fund you are personally comfortable with. I decided to fund my Emergency Fund while simultaneously paying off debt and investing. We were able to get away with this since our jobs were very stable and thought the rewards of investing outweighed the risk.
Investment Decisions – One of the most important factors is how you are going to allocate your money. You are trying to compare your interest payment versus investment gains. Personally I use the average expected return when making this decision. Unless you are invested in guaranteed returns, you will not be able to definitively state what your returns will be. While this is unsettling to think about, if you are invested long term you can expect to be in the same ballpark as historical averages.
Thinking Ahead – You situation could change at any time. Do you have large purchases coming up? Are you going to have kids? Do you plan on changing careers? Depending on the answer to these questions you may tweak your investing/debt payoff ratio.
A.E. Approach – Invest or Pay Down Debt
Before I break down what the A.E. approach, I want to say this may not be the best path for you and your family. This post is to get you thinking about your priorities, not taking my approach and making it your own.
Our current situation:
- 3 open debt channels – Mortgage (4% interest rate), Student Loans (4.075%) and Car Loan (.9%)
- Our Emergency Fund is almost fully funded (by end of 2016)
- At least 10 Years to official retirement (hope to be out of the corporate world a lot sooner, but not officially retired)
- We plan on having kids in the next few years
- Since we are both under 30, we are on the aggressive side of investment portfolios
Given the above variables, we have decided to focus more on investing than paying off debt. The ratio of investing to accelerated debt payoff is around 10 to 1. We pay an extra $200 a month on my student loans to get rid of them slightly faster (they are a black mark on my financial record, and I cant wait to get rid of them).
The reasons behind the 10 to 1 approach are pretty simple:
- Our interest rates are low enough that we can do better investing (all well under 5%)
- Our jobs are very stable, so the monthly payments aren’t that daunting (for now)
- We will focus on paying off our mortgage after we have built a massive nest egg
- We do not plan any large expenses outside of having children in the next 5 years*
*We may start paying off my student loans faster when our next salary increase goes through, at one point the $1,000 a month payments will become more of a liability.
I don’t think there is an 100% right answer to this question. My recommendation would be to kill any debt over 5% then start splitting your money between investing and debt payoff at a ratio that is comfortable for you.
One over looked approach to getting rid of debt over 5% is consolidation (especially for student loans). Prior to my refinance Student Loans interest would have been above the 5% interest barrier.
For anyone with a mortgage, it might be time to look at refinancing as an option. Rates are really low right now and I will be looking into a refinance over the next 2 weeks to see if it makes sense for us.
Don’t leave money on the table, if you get an employer match on 401K investing is a no brainer over paying down debt up to the match limit.
What is your approach? Do you invest or pay down debt first?