What Should Come First: Paying Off Debt or Investing?
Which amount will be bigger: the interest you have to pay on your debt or the potential return on your investments?
It’s the classic chicken or the egg scenario in the personal finance world: If you have a little extra money in your budget, should you pay off your debts first, or start investing for your future?
On one hand, paying down your credit card balance or loans will save you from paying extra interest over extended periods of time. On the other, the earlier you begin investing the more opportunity you have to grow your money.
So, which strategy will be more lucrative for you in the long run? Like many financial questions, there’s no one-size-fits-all solution. The ideal debt-or-invest strategy will be different for everyone, and depends on how much debt you have, your income, and your goals.
Let’s start thinking about the current landscape and your specific circumstances. Once you’ve got a better lay of the land, you can make an informed plan that will get your money working toward building the future you want.
When it Comes to Debt and Investing, Are You a Typical American?
Debt is a big part of life for most Americans. According to a recent survey, the majority of us are currently in debt, with 79.9% of Gen Xers and 81.5% of Millennials owing money. That debt is also higher than ever before, averaging nearly $7,000 for households carrying a credit card balance from month to month. When we consider all demographics and debt types (excluding mortgages), the typical American owes $38,000.
So, for many people, making a dent in their debt is top of mind, and an important step toward building financial stability.
At the same time, when we take a look at investing statistics, 46% of Americans don’t own stocks. When it comes to planning for retirement, the difference in participation is even starker: According to the U.S. Census Bureau, two-thirds of all Americans don’t contribute to a 401(k) or other employer-sponsored retirement account. Considered together, these stats show there’s a large segment of the population that’s missing out on the wealth-building opportunities that can come with investing.
So, collectively, we’ve got a lot of debt to pay off and a lot of catch-up to do in terms of investing. Individually, like many Americans, you may feel a sense of financial paralysis: You know you need to pay off your debt, but you also want to invest to grow your wealth in the years to come.
This brings us back to our original questions: Should you pay off your debt or start investing? Which strategy makes sense for you?
Should I Pay Off Debt First?
Imagine what your life would be like if you didn’t have any credit card bills or student loan payments. Sounds fantastic, right? When you pay off your debt, you gain financial freedom. Your income that previously went to paying down your credit cards, your car loan, or other obligations is now free for you to use toward building your wealth.
On the flip side, not all debts are created equal. High-interest credit cards and private loans, for example, can grow to unmanageable amounts if you only pay the minimums each month or you go on a spending spree. (Although we’re guessing you know better than that!) Long-term loans like mortgages and federal student loans, however, are usually structured so monthly payments stay fixed over several years, meaning you can plan in advance how they’ll fit into your budget. So, depending on the type of debt you have, it may not make sense to go with a debt payoff strategy first.
The first step to understanding your ideal strategy is to figure out what you’re dealing with, so take some time to tally up all your debts. It may not be the most enjoyable exercise, but you need to know: How much debt are we talking about here? What types of loans do you have and what are their interest rates?
To add up how much debt you’re carrying and what you can expect to pay over the life of your loans, use an online debt repayment calculator to add up the totals for what you’ve borrowed, estimate what will accrue in interest, and play around with payoff timeframes.
From there, you should get a better grasp of which debts should be addressed immediately (if any) and which are OK to pay off over a longer period of time. When you have a full understanding of your debt obligations, you’re halfway toward figuring out whether it makes more sense for you to first pay off debt or get started with investing.
Pros of Paying off Debt First: Financial freedom and flexibility.
Cons of Paying off Debt First: Starting late with investing and missing out on the potential for growth over the long term.
Should I Invest First?
When you invest your money, you’re aiming to grow your wealth over time, often with the goal of matching or outpacing inflation, which is currently 1.91% a year. Investing is a long-term strategy that means the value of your money can increase, hopefully at a faster rate than if you put it in a regular savings account, which averages just 0.1% growth a year.
If you decide to invest first, you’re taking advantage of having your money invested at an earlier point than if you waited until you had paid off your debts. The benefit of this early start is that, over the long term, equities can lead to significant growth.
To get a sense of what could happen when you start investing early, let’s look at two hypothetical investors, Amy and Todd. Amy starts investing $2,400 a year in 2019, whereas Todd starts investing that same amount a decade later. Here’s how much they could have over the next 50 years, assuming their yearly investment amount doesn’t change and they get a 7% rate of return each year.*
*Based on the historical stock market rate of return
As the chart shows, by getting a head start, Amy’s nest egg has become more than twice the size of Todd’s – even though they’re presently putting aside the same amount of money each year. The more time your money can be invested in equities, the more your money may grow, and that growth can be dramatic. When it comes to investing, the early bird can get a lot more worms.
Remember, too, that if you invest while still having debt, you want to make sure you still have enough cash on hand to meet your debt obligations and make all minimum payments on time. It’s great that your investments are growing, but if your debt is growing, too, you’re not building wealth free and clear.
Pros of Investing First: More time invested, plus access to employee match retirement programs, may be a means to greater wealth.
Cons of Investing First: You still carry debt obligations, and you may not have as much cash on hand for unexpected expenses.
Speaking of unexpected expenses, let’s say you have an emergency like a medical issue or a broken refrigerator, and need cash that’s currently devoted to your investments. Depending on your investment accounts, you may be able to access your money at any time, but ideally you’ll want to leave it alone to let it grow, or you’ll lose out on all the gains you may have already built up. Which brings us to…
Do You Have an Emergency Fund?
As you start to think about investing or paying off debt, you also want to take your day-to-day expenses into account, plan for the unexpected, and take steps to set yourself up for success. You want to make sure you first have an emergency fund for life’s surprises. It’s a good idea to have at least three months’ worth of living expenses saved and easily accessible in case of an emergency.
An emergency fund gives you peace of mind and keeps you on track so you can go after your bigger goals. Once you have your emergency fund built up, you’re then in good shape to start paying down your debt or get started with investing.
How Do I Crunch the Numbers?
Once you’ve set up your emergency fund, tallied up your debts, and started learning about potential investments, it’s now time to actually look at which strategy will help you grow your wealth. From the numbers themselves, is it better for you to pay off your debt first or start investing?
To find out, you want to understand which amount will be bigger: the interest you have to pay on your debt or the potential return on your investments. If the debt interest is larger, you may want to prioritize paying off debt. If the potential return on investments is higher, consider getting started with investing. (Remember, of course, that if you prioritize investing, you still want to make sure you’re making your minimum monthly debt payments on time to protect your credit score!)
Can You Pay Off Debt and Invest at the Same Time?
In a word, yes! Once you have your emergency fund set up and you’ve understood the scenarios that could apply to you, you may realize that a simultaneous debt payoff and investment strategy makes sense.
For example, you could start paying down your high-interest debt while also taking advantage of your employer’s 401(k) plan, contributing up to what’s matched. Or, you could pay off your high-interest credit cards while also exploring digital platforms where you can invest with impact. With COIN, for instance, you only need $50 to get started with investing, which may be manageable for you to invest while also paying down your debt. Depending on your budget and long-term plans, you may not need an either/or approach when it comes to paying off your debt and investing.
As you start moving toward your goals, it’s a good idea to check in with yourself every few months to make sure you’re still on track. Look at your debt balances monthly to see how much headway you’ve made, or take a peek at your portfolio to see if it grew. Additionally, be sure to celebrate any wins or milestones, like completely paying off a credit card or getting your first year of investing under your belt, with a reward that fits your budget and is also significant to you. For some of us, this might be a vacation. For others, it’s a fancy latte. Make it personal and meaningful to keep your momentum going.
Whatever tactic you decide, your proactive, goal-driven approach already shows progress toward achieving financial freedom. When you make informed financial decisions and take action toward positive change, you’re designing your own future on your own terms.