Point of Interest
The answer to whether you should pay down debt or invest depends on the amount of your debt and the potential returns on your investment options.
When you hear someone ask the question, “Should I invest or pay off debt?” you know one thing for sure — the person who is asking cares about their financial future. When you have extra money come in, deciding whether to allocate those funds to the bank or to the piggy bank is critical to the success and growth of your financial future. There is a right answer as to whether you should pay off debt or invest, but it depends on the unique factors of your personal circumstances.
How to choose between paying off debt or investing
Chances are that your financial goals are to become debt-free and build your finances and investments for the future. While both of these goals are aimed at financial independence, they can seem contradictory to each other at times. Paying off your debts takes money from your investments and vice versa.
For most people, the answer as to whether to pay down debt or invest is to start with your debt first. The reason for this is that the debt is actually costing you money. Holding off on making investments does not cost you anything except for potential returns. While your investments could make you money, the gains will have to be higher than the money you’re losing to the debt before you’ll profit.
Now, if the money you can make from your investments is more than your debt is costing you, it might be in your best interest to invest and then use the proceeds to pay down your debt. In most cases, though, the math is going to show that you should pay down your debt first. And to be clear, if you do still have debt, taking on higher-risk investments might not be the best idea. If you lose your invested funds, you still have debt payments to make.
The bottom line is this: in most cases, based on average debt costs and average lower risk investment returns, you are better off clearing out your debt first and then focusing on growing your investments.
When you should pay off debt
- In most cases — In most instances, start with paying off your debt. Generally, the money you are losing from your debt will cost more than you can make from investments with an acceptable level of risk. While paying off your debt may put investing on hold, it will be temporary. Once your debts are paid off, you can allocate 100% of those funds for investments.
- When your debt costs are higher — Take a look at how much your debt is costing you every month. Compare that to the return you’ll be getting on your investments. And remember that not all investments have a guaranteed return, which means that you need to look at best, worst and most probable scenarios for your return on your investment. It’s also important to note that your debt payments are guaranteed to be there until they are fully paid off.
- When you want to make a major purchase — Your FICO credit score is used in over 90% of lending decisions. The amount of outstanding debt that you have accounts for 30% of your total score. If you are looking to make a major purchase in the future (like a car or a house), you may consider paying down your debt to improve your credit score. Not only will this help save you money on the interest you’re paying over time, but it should also help you get a lower interest rate (and better chances of approval) on that upcoming purchase.
When you should invest
- When your future is uncertain — There are times in life when things are less than certain. If you find yourself in a situation where your financial future and income are volatile, you may want to allocate more of your money to an emergency investment fund. This needs to be highly liquid and can be used in case you lose your job or your source of income. Remember, even if you lose your job, most debts require that you keep making payments. This emergency fund could help if you find yourself in that situation.
- When there are added investment incentives — You may be eligible for added investment incentives that are not going to be available forever. One example of this is an employee-matching investment program. If your employer is matching a percentage of money that you invest in something like a 401(k), you need to figure that into the equation. If that increases your investment gains over your debt costs, it could be worthwhile.
- When there are tax benefits — Another instance where added incentives need to be factored in is with tax benefits. Some investment products offer tax incentives that may increase the value of the return. Make sure you calculate tax breaks into your math when determining if you should pay down debt or invest.
The final word
The fact that you’re asking, “Should I invest or pay off debt?” is a great sign that you care about improving your financial picture. In most cases, paying down your debt first is going to be the right option. However, if you’re getting investment incentives or your future is uncertain, you may want to consider investing or saving some money first. Otherwise, pay down your debt. Once your debt is gone, you can allocate 100% of your extra funds to your investments with no debt looming over your head.