Should I Pay Off Debt or Invest?

Question of the Week

"Hey Treyton, should I pay off debt or invest?"

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Having debt is stressful and it makes sense to think all money should be going towards debt to get rid of it as quickly as possible. However, this may not always be the case.

When deciding if you should pay off debt or invest, it's important to first take a look at your overall financial picture. A few things you want to know before answering this question are:

1. What are the interest rates on the debt?

2. Do you have any current savings?

3. Are you contributing to your company's 401(k) up to the company match?

1. If the debt has a high-interest rate (over 7-8%), it may make sense to put more money towards the debt instead of investing because by paying it off, you're effectively getting a return on your money equal to the interest rate on the debt. If it's credit card debt, the interest rate may be 15% or higher and it'd be hard to match those returns when investing in the stock market - so paying it down before investing might make more sense.

If your debt has lower interest rates, like a mortgage for example, paying off the debt early probably isn't the best use of money because it's possible to get higher returns in the stock market.

2. Having current savings is important because if you have debt, no savings, and start investing - if anything unexpected happens that you have to pay for, you'll have to take on more debt or sell investments to cover the expense. But if you work on building a small emergency fund or other savings, you can cover any new expenses without taking on more debt or affecting your investments.

3. If your employer has a 401(k) match, typically it makes sense to invest up to the company match even if you have some debt. This is because your employer is giving you free money just because you decided to invest.

Ideally, it's best to strive for both investing and pay down debt at the same time. The reason being is that time is the one thing we can't get back. If it takes several years to pay off debt, that's years of investing that are being missed. And when you're young, you have the most time to let your investments grow and experience compound interest.

This chart below shows the difference between one person getting started with investing at 25 and contributes $150,000 and one person who waits until 35 to get started and invests double the amount, $300,000.

The person who starts at 25 ends up with over $200,000 more at retirement even though they contributed $150,000 less.

How can that be?

That my friend, is the power of compound interest and investing early.

via vanguard.com - assuming 6% annual returns

Depending on your overall financial picture - it's best to try and invest if you have some debt, even if you're only able to invest $50 or $100 a month.

Take some time and think about what makes the most sense for your situation because some people absolutely hate debt and are willing to give up investment returns to get debt out of their life. And then for others, debt isn't as big of a deal and they recognize the importance of investing early.

There's no one-size-fits-all answer because everyone's situation is different but overall, if you have a lot of high-interest debt - you want to get rid of it. Develop a debt pay-off plan and if there's any money left in your budget after paying down debt, even if it's $50, investing that money will help in the long run.

If you only have a little bit of low-interest debt, prioritizing investing generally makes sense because you may be able to earn higher returns in the stock market than the low interest rates on the debt.

Financial IQ #5 - 5.16.21

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