Carrying high debt balances can feel like walking around with a weight on your shoulders and deciding whether to pay down debt or invest is a tough decision to make.
But should you strive to reduce your debt, or place your money in a retirement savings account or other investments? There’s no one right answer for whether you should pay off debt or invest, plus everyone’s situation is different.
Below are a few things to consider that can help you make the decision that’s right for you.
Why Should You Invest First
How Much Debt Are You Carrying
If the amount of debt you have is low, it makes sense to invest your extra money outside of your debt payoff plan. This is because a small amount of debt isn’t likely racking up much in interest charges.
If you have a large amount of debt, you should pay it down so you don’t rack up more debt through interest. Interest charges can accumulate quickly and cost you more in the long run than if you’d prioritized paying down the debt in the first place.
Your Retirement Investment
Many employers match 401(k) contributions up to a certain percentage, typically between 3% to 5%. Your employer match is not only free money you can invest with; it’s part of your overall compensation package. Not taking it is like handing a portion of your salary back to your employer. You’ll want to prioritize getting the full match instead of paying down debt.
There’s also a tax benefit to investing in your 401(k) that you’ll want to consider too. Tax-advantaged retirement accounts like your 401(k) use pre-tax dollars. Not only can you benefit from your employer match, but fully contributing to your 401(k) can lower your taxable income in the short term.
If You Get Extra Cash
If you receive extra cash such as an inheritance or a bonus at work, use that money to first shoring up an emergency fund. For modest windfalls, consider splitting cash between debt (60%) and investment (40%). put enough of the windfall toward debt to get the monthly payment down so that the overall balance can be paid off in months rather than years.
Why Should you Paydown Debt First
Debt Interest Rate
One of the biggest issues with debt is interest. If you have high-interest-rate credit card debt, it makes sense to pay it off first or get a lower interest rate. Interest rates, especially credit cards, are so high that you can never get ahead.
If you are investing when you have credit card debt, you are likely paying a higher interest rate on your debt than you are earning on your investments. Unless you have a huge amount in investments, you end up losing money overall.
To Boost Your Credit Score
Another solid reason to pay down is to improve your credit score. Your credit score can even affect other aspects of your life, such as the premiums you’ll pay for insurance, whether a landlord will rent to you—and even whether an employer will hire you. Having a low credit score can mean paying higher interest rates, if you can get a loan at all.
Credit scores are based on a number of factors. Such as your credit utilization ratio that is the amount of credit you are currently using compared to how much credit you have available to you accounts for a significant portion of your score. Someone whose credit cards are all maxed out is likely to have a considerably lower score than someone whose credit cards have been paid off or at least paid down to a more reasonable level.
Can You Pay Off Debt and Invest?
You don’t have to completely commit to paying off debt vs. investing. You can also find a balance between the two and work toward achieving multiple financial goals at the same time. Here are two reasons why investing while paying off debt is important:
Striking a Balance Between Financial Goals
Focusing all your efforts on getting out of the red may feel like the right thing to do, if only to cut down the amount you’re paying in interest. But if you fail to save or invest during this time period, you may have a net worth of zero when you eventually are free of debt.
By putting some money into savings while you simultaneously work to repay debt, you can make progress toward important financial goals (like saving for retirement through your company’s 401(k) plan as you eliminate debt.
Paying Off Debt is Important, but You Need to Invest In Your future
Imagine if you were to become disabled and no longer able to work, or if your spouse passed unexpectedly. Would you be prepared? The costs of dealing with these situations without proper protection and income strategies would be far greater than paying interest on your debt for a few months longer.
The Bottom Line
Paying off debt can reap some valuable financial rewards in the short-term. Meanwhile, getting a jump on investing can benefit you in the long-term.
Before deciding whether you want to prioritize paying off debt or investing, you’re going to want to crunch some numbers. Aggressively paying off low-interest debt or debt tied to an appreciating asset, like real estate, might not be the most financially advantageous move for you. If the gains are higher than the cost of financing your debt, it could be worthwhile to invest at least some of your money while continuing to make your minimum debt payments.
But you’ll want to prioritize paying off debt if you have high-interest credit card balances. This type of debt is not only expensive to finance but can negatively impact your ability to access less expensive lines of credit in the future. This can wind up costing you more money in the long term while also degrading your quality of life in the short term.
It is therefore important to weigh all factors to determine what option would be better for you because deciding what approach to take.