Paying off debt may take what feels like forever, so you may be thinking about investing as a way to cover some of your financial ground. However, it can be tricky to decipher whether paying off debt should take priority or take a backseat to investing. Should you tackle debt and then invest, or try chip away at one while growing the other simultaneously? This article outlines how to make sense of this personal, and hopefully prudent, choice.
If you have been a student of higher education and/or purchased a house in the past few decades, the chances are high that you’ve got at least a bit of debt, if not a substantial amount. This also goes for those of you who may have bought the car you always wanted, you leased furniture, have large medical bills, etc. In today’s day and age, it seems that debt is the ubiquitous ball and chain we are forced to drag along throughout the many stages of our life.
However, an increase in your personal funds may have you pondering the possibility of investing some of it in order to grow your assets over time. Thus, you find yourself faced with one of finance’s age-old questions— should I invest or pay off my debt?
First, let’s focus on answering why both are worthy contenders of comparison. You already know that paying off debt and investing are both fairly important in the hierarchy of money management, or you wouldn’t be reading this. But there are a few things to revisit before deciding which is your top priority. After all, personal finance is based on your personal priorities. Nevertheless, there’s a good chunk of common sense and smart planning that can leave you with more money in the bank at the end of the day. So let’s review.
Pros of Prioritizing Debt Payments
Firstly, the importance of paying off debt. This is crucial, as failing to do so may bring you more negative impacts to your life than you’re aware of. At the very least, you want to be making the minimum payments on all your debt before you even consider investing. This should be a top priority. Not meeting minimum payments will only increase the debt you already have through late fees and additional charges, and worse – it can cripple your credit score. So make sure that base is covered before you go forward with any other extracurricular financial endeavors.
This aside, paying off loans can be mentally and emotionally freeing. Being debt-ridden tends to leave most of us with the feeling of carrying a bell-bar across our shoulders that we didn’t even know was there until it’s been removed. From a financial perspective, it can raise your credit score, giving you higher chances of being approved for a mortgage or a business loan, and will automatically decrease your costs when you stop paying that never-ending interest.
The Perks of Investing
We have all read or heard stories of those who have ‘made it big’ through investments. While average investments don’t make the news, they can certainly make you more capital. Investing gives you the opportunity to grow what you already have at no cost (save the varying levels of risk involved). With know-how and smart investment strategies, it is possible to turn a quick, medium, or long-term profit on your money, which can increase manifold. What’s more, if you choose to invest in the stocks of a company, you automatically own a stake of its ownership, which could even give you a say in business decisions.
A note of caution: make sure that your plan to either invest or pay off additional debt does not leave your checking account at zero. It’s important to have a reserve around 1.5 the size of your average salary at your disposal. If you think you don’t need this, think about the last time you had to pay a large medical bill, fork over hundreds for a car replacement part, or buy a last-minute plane ticket. Having the funds to pay these types of one-off costs will save you from wracking up more debt, and creating a vicious cycle of working to pay it off.
Debt Payment vs. Investment Conundrum
With those prefaces in mind, a debt payment versus investment conundrum will boil down to comparing interest rates. If you have debt with a high-interest rate, i.e., 10% or above, you’ll want to focus on paying that down before you turn to investing. This is because the average amount that your investing could bring you would be less than the amount your interest rate will require of you. Thus, any debt that is accumulating high interest, like credit card debt (which has an average interest rate of more than 17%), is the first thing to be paid off, and the quicker the better.
Let’s say instead that you are one of millions of American university graduates with student loans (the average student owes a whopping $39,400), which usually boast lower interest rates. While you are steadily paying off your hefty debt each month, you’re making a steady income and considering investing some of it. Again, the choice to chip away at your debt vs. invest will come down to the interest your lender is collecting from you.
Without getting into the nuts and bolts of investment returns, numbers over the past century have shown that the average “long-term hold-and-buy” (keeping your investment where it is rather than flipping stocks constantly) investor in the stock market can expect to make a 10% return. Keep in mind that one; there are many more ways to invest than in the stock market; secondly, this is just an average, and thus, fewer people actually walk away with that amount.
Now that we have a (very rough) investment average, you can try that on for size and see how it measures up against your debt. If you’ve got debt with, let’s say, a 3% interest rate, and you have extra money above your reserve to invest, you have a decent probability of making a small profit through an investment that could both cover your debt interest, and leave you with a modest return. If you have an interest rate closer 8%, your margin for investment error gets smaller and smaller. You can alter this logic based on the average return of the particular investment you are looking into.
Getting your Interest Rate Down and Increasing Your Investments
If you don’t like the interest rate that’s slowing eating away at your monthly debt payments, I don’t blame you. Luckily, there are several options to lower that rate, the most common of which is refinancing. In simple terms, refinancing is when you open a new contract on your debt with a lender that can offer you better terms than those in your current contract, i.e., a lower interest rate. You can save hundreds a year and thousands over the life of your loan by doing this, so it’s definitely an option to look into, whether you plan to invest any of your money or not.
If you are eager to invest in your future but you aren’t ready to fork over the cash you’d really like to put towards your debt, you could focus on finding a job at a company that matches your 401(k) payments. Turns out that about three-quarters of companies in the US do, so that already gives you a leg up. The average match is 3%, but some companies go as high as 10%. According to data from the Bureau of Labor, the highest 401(k) matches are paid out by larger companies with 100+ employees.
Alternatively, if you want to get your feet wet with investing without a lot of risks involved, give micro-investing a shot. There are a host of resources out there that can guide you, like Acorns, an app that helps you squirrel away as little as one dollar a month put towards micro-investments. Tossing a few bucks into a virtual piggy bank that grows over time could end up being the solution for a new generation of debt-saddled millennials.
Whichever route you choose, remember that there is no wrong way to do personal finance, as long as you are making the choice that feels most comfortable to you – and of course, you’re not hitting zero before the next paycheck comes.