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Invest or Pay Off Debt?

SHOULD YOU INVEST OR PAY OFF DEBT?

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Invest or pay off debt? A million-dollar question! I’ll start by saying that both are excellent financial decisions as they increase your net worth and bring you closer to financial independence. If you are pondering this question, you are moving in the right direction. 

However, which option should you prioritize to place you in a better financial position?

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This article will address the following sub-topics:

  • Factors that determine whether to invest or pay off debt
  • Pros and cons of investing and paying off debt
  • Approach for someone with more low-interest debt (good debt)
  • Approach for someone with more high-interest debt (bad debt)

FACTORS THAT DETERMINE WHETHER TO INVEST OR PAY OFF DEBT 

1. WHAT TYPE OF DEBT DO YOU HAVE? 

You may be familiar with the idea of “good” debt and “bad” debt. An asset typically secures good debt, while bad debt does not have any collateral. 

Being secured enables good debt to have a lower interest rate. On the other hand, since bad debt is unsecured (such as credit card debt), it will have a higher interest rate.

The main distinction between good debt and bad debt is the rate of interest. 

A good measure is the rate of return in the stock market, which historically has been about 7% after adjusting for inflation. 

If the interest rate on your debt is below the average stock market return, it can be considered good debt. Otherwise, regard it as bad debt.

Side note: Generally, avoid any kind of debt as much as possible. A 2.50% $300,000 25-year 25-year will result in interest payments of about $100,000 over the life of that mortgage. In essence, you would be paying one third more in interest in the price of your home!

If you have any bad debt, tackling that should be the priority before investing. 

If you only have good debt, you have greater flexibility to decide what makes the most personal and financial sense.

2. WHAT ARE YOUR GOALS? 

Assuming one has low-interest debt only, investing extra income (while making all the minimum monthly debt payments!) typically makes more mathematical sense than aggressively tackling debt first. The reason being that returns on investments will likely outweigh the debt interest.

However, whether to invest or pay off debt is not always apparent since psychology and individual goals also come into play.

People are typically motivated by various (often unintuitive) things. Seeing the numbers decrease each month may be a great incentive to keep paying off debt first. On the other hand, some people may be highly motivated to achieve early retirement. The latter group will be more highly motivated to invest and grow their nest egg.

3. ARE YOU READY TO INVEST? 

If you find yourself leaning toward the investing option, you should find out whether you are ready to do so. 

One essential preparation is building an emergency fund first. These are funds set aside to cover unexpected expenses such as medical bills, home or car repairs, etc. Setting up an emergency fund is crucial because not having one on a rainy day could lead you into more (often high interest) debt to cover financial surprises.

Learn about the other factors that can help you to determine whether you are ready to invest here.

PAYING OFF DEBT 

PROS 

  • Most people naturally worry about getting out of debt (mortgages, student loans, car loans, etc.). Carrying debt can cause a lot of stress, shame, embarrassment, frustration, anger, and even marital problems. Paying off debt lifts this psychological weight and the adverse effects associated with it.
  • One of the main advantages of actively paying off debt is that you pay less interest over time. Incurring a lower interest expense allows you to free up extra income to invest or spend on other things that may improve your overall quality of life.
  • Accumulating debt to high levels that exceed your overall credit limit will negatively impact your credit score rating. By becoming debt-free, you raise your credit score, allowing you greater financial flexibility.
  • The impact of paying down your debt is immediate, and it provides instant gratification knowing that each payment brings you closer to achieving your financial goals. This gratification is often a great motivator to aggressively pay off debt and watch with much satisfaction as the amounts decrease with each payment.

CONS

  • Paying off debt instead of investing puts your financial goals on hold by losing time in the stock market. Depending on the type of debt you carry, investment returns may outmatch the interest savings from paying off your loans.
  • Unlike investing in the stock market where you can easily access the funds if needed, paying off debt leaves you with few to no liquid assets. Once you have made a payment to your lender, you cannot get that money back even if it was a prepayment.
  • Interest expenses are tax-deductible, which means that the faster you pay off debt, the less interest you will have to apply against your taxable income.

INVESTING

PROS

  • You can deduct a considerable portion of your income for tax purposes when investing with tax-advantaged retirement accounts. Such deductions lower your annual tax burden and leave you with a more significant sum to invest. Furthermore, retirement accounts are exempt from creditor claims.
  • Although an emergency fund should take care of any immediate financial needs, investing allows you to have quick access to liquid assets, such as stocks and bonds.  
  • It allows you to take advantage of employer-matching programs, which equates to an immediate and guaranteed return on investment. An employer’s match is virtually free money; never leave free money on the table. 
  • Investing also provides financial peace of mind in knowing that you have enough to cover your debt and earn higher returns. Generally, investment returns will be greater than debt interest payments.

CONS

  • It is possible to lose money by investing in the stock market due to various factors such as company performance or the overall market conditions. However, markets always rebound and have an upward trajectory in the long-run.
  • Investing is not as straightforward as paying off debt. It has is a learning curve and may require a lot of time to perform research, investment analysis, and monitor the market conditions.
  • There are fees associated with investing, and if not monitored properly, they could decrease your investment returns significantly.
  • Investing is a marathon, not a sprint, which means that it does not provide instant gratification. It takes time and patience for compounding to work its magic and for your investments to grow.

APPROACH FOR SOMEONE WITH HIGH-INTEREST DEBT 

If you have high-interest debt (i.e., bad debt) below are some steps you should consider:

  1. Build an emergency fund to cover about 1-2 months of expenses (a deviation from the ideal of 3-6 months of expenses because high-interest debt can be financially devastating)
  2. Analyze your costs and develop a realistic budget. Learn how to create a budget here.
  3. Make lifestyle choices that can help you reduce your expenses and look for ways to increase your income.
  4. Take advantage of any employer contribution matching programs up to the maximum amount
  5. Aggressively apply all your extra income to paying off debt

APPROACH FOR SOMEONE WITH LOW-INTEREST DEBT 

If you have low-interest debt (i.e., good debt) below are some steps you should consider:

  1. Build an emergency fund to cover 3-6 months of expenses
  2. Analyze your costs and develop a realistic budget. Learn how to create a budget here.
  3. Take advantage of any employer contribution matching programs up to the maximum amount
  4. Make all the minimum monthly debt interest payments
  5. Understand investing basics and put all your extra income into appropriate investments. Learn the basics of stock market investing here. Some brokerage firms such as TD Direct Investing can also provide a lot of learning material.

BOTTOM LINE

Finance is more than just mathematics, and there isn’t a one size fits all. Always make financial decisions that align with your personal goals and values.

If you enjoyed this article on whether to invest or pay off debt or have any questions, please leave them in the comment section below! I’d love to hear from you! Also, please feel free to share this with anyone that may benefit from it as well.

“All our dreams can come true if we have the courage to pursue them.” ~Walt Disney

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Should you invest or pay off debt?

Sharing is caring!

TAKE CONTROL OF YOUR PERSONAL FINANCES

download-750x952

Ever feel like money just seems to slip through your fingers month after month? Our Monthly Budget Tracker will guide you to start making the most of every dollar. It’s a game changer—get it free for a limited time!

Nikki Kirimi

Nikki Kirimi is a finance professional (MBA, CPA, CMA) and the creator of Money World Basics. She enjoys acquiring and sharing personal finance knowledge to help people better their lives.