Have you cut back expenses, earned a raise, or found some cash in between the couch cushions? If you find yourself with a little extra money in your pocket you may be wondering whether you should pay off your debt or invest. Let’s break it down.
First Steps
Before you begin accelerating your debt payments or implementing an investment strategy make sure that you have your basics covered.
Make sure that you…
- Pay the minimum of all debts
- Have a 3-6 month emergency fund
- Take advantage of your company’s 401(k) match, if any
If you have completed these three steps and still have extra money it’s time to consider how best to put that money to work.
An Investment with a Guaranteed Return
What if I told you that I knew of an investment that had a guaranteed return of about 15 – 22% per year. Would you be interested?
Well, that’s exactly how much you would make from paying off your credit cards! This is because whenever you pay off debt, you are basically “making” a guaranteed return equal to the interest rate of the debt you paid off. We aren’t taught to think about paying off debt as an investment. When someone says “investing” we usually think about putting money aside today to make returns tomorrow. But what if we widened the definition to include paying money today to avoid paying interest tomorrow?
If we think this way, the question is no longer “should I invest or pay off debt” because paying off debt is a form of investing itself. The real question is which investment is best for your risk tolerance, emotional well-being, time horizon, and goals. To help you find out let’s do a quick exercise.
Which Is the Better Investment for you?
Take out a piece of paper.
On the left side of the paper write down each type of debt you have and the interest rate.
On the right side write 7% with a big question mark. This number represents what you can expect to earn from a well-diversified portfolio of stocks and bonds. Keep in mind this is just a best guess, it is in no way guaranteed. Nor will it be a smooth ride. There will be tremendous highs and crushing lows that over time will most likely average out to 7% return per year.
Now you have a choice. Pay off your debt with a guaranteed return or take a shot at the 7%. Which is right for you?
With credit cards, it’s a no-brainer. Why take a shot at 7% when you can earn a guaranteed 15-22%? But with other debt (for example a 5% mortgage) it’s a bit more nuanced.
For some people, it may make sense to take the 7% shot. On average you’ll make more, and on a spreadsheet, this makes perfect sense. But life doesn’t take place in the spreadsheet. It’s important to consider the emotional burden that debt has on you. Debt has been shown to induce feelings of shame, guilt, and helplessness.¹ So even if the return may be less on average the emotional benefits of paying off debt can make up for the difference.
So, which is it?
The answer to this question depends on many personal factors, but here is my basic guideline:
If your interest rate is…
- Less than 3% = Pay it off slowly and direct any extra money to your brokerage account
- Between 3% and 6% = Do whichever is more comfortable for you, debt payment or investing in the market
- More than 6% = Take that guaranteed return and pay off the debt as fast as possible
As I’ve pointed out, this may not be the best guide for you. If one of your goals is to be debt-free you may find that you want to prioritize paying off all debt, no matter the interest rate.
Other than credit card debt, you will probably make more on average from investing in the market than paying off debt, but even still you should strongly consider paying off your debt first. I have never met anyone who has gotten debt-free and regretted their decision.
Talk to your Financial Planner or Investment Advisor about your personal situation and goals so you can incorporate a debt payoff schedule and investment strategy that makes sense for you.
