Deciding whether to pay off debt or invest can be tough. They are two competing financial goals, and you may wonder which one takes precedence. Eliminating your debt as quickly as possible has its advantages. Yet there’s a strong case for getting an early start with investing. Considering the benefits and potential drawbacks of each can help you decide which strategy is best for your financial situation.
Paying Off Debt First: The Pros
Credit cards, student loans, car loans or any other type of debt can take a toll financially and mentally. It can be frustrating to have to commit a percentage of your montly income to repaying debt. It also could leave you with less money to cover your basic living expenses.
There are several reasons to consider paying off debt before you start investing:
- The sooner you eliminate debt, the less interest you will have to pay on that debt..
- With no debt payments, you may have more money in your budget to save and invest.
- Reducing debt can improve your credit score, which is important if you want to buy a home or finance a vehicle.
There are mental and emotional element to paying down debt as well. Being able to escape credit card or loan payments for good can take a weight off your shoulders. Waiting to pay off debt, on the other hand, means you carry that burden longer. Not to mention, you’re also racking up more interest charges.
Say you have a $10,000 credit card balance at 17% interest. If you pay $500 a month, you’d clear the debt in 24 months and pay approximately $1,842 in interest charges. Now, say you cut your monthly payment down to $250 instead. In that scenario, it would take you 60 months to get rid of your balance and you’d pay $4,862 in interest. That can be a great motivator for speeding up your debt payoff as much as possible.
Benefits of Investing Early and Often
There’s one very important reason to start investing sooner, rather than later: compounding interest.
Compounding interest is the interest earned on your interest. Essentially, when you invest money and earn a return, that return compounds based on what you’ve earned and your original principal investment. In other words, compounding can help your money to grow without requiring any extra effort.
The younger you are when you start investing, the more time works in your favor. Assume you open a Roth IRA on your 25th birthday. You commit $6,000 per year (the annual contribution limit as of 2019) to invest in your account. By the time you turn 65, your money will have grown to $1.28 million, assuming a 7% annual return. That growth is largely thanks to compounding interest.
When you focus on debt first and neglect to invest, you miss out on the benefits of compounding interest. Going back to the previous example, assume you wait five years to start investing until you pay off your debt. That would potentially shrink the value of your Roth IRA to $796,000. That’s still not too shabby, but you’re trading off $494,000 by waiting an extra five years to get started.
Tax Benefits of Investing
Another reason to consider investing ahead of paying off debt is the tax benefit associated with carrying certain debts. Student loan interest and mortgage loan interest, for instance, are tax-deductible. Deductions reduce your taxable income for the year, meaning less of your money is taken by the IRS.
Putting investing first could also make sense if you’re carrying lower rates on credit cards or other debt balances. The money you could earn by investing in stocks, mutual funds or other investments could outweigh the interest paid to your debt if the market is performing well.
Can You Pay Off Debt and Invest?
It’s possible to do both if you have a plan. That begins with having a detailed budget that outlines your income and expenses.
Advisors recommend dedicating every dollar you make to a specific goal. It could pay bills, go into savings or pay down debt. Setting goals and organizing your income can make it easier to track your progress. Make sure your goals have a clearly defined number and that you give yourself a deadline for reaching them.
It’s also important to go over your budget to find “extra” money you could use to save or invest. For example, cutting out subscriptions or canceling an unused gym membership can free up a few extra dollars.
Decreasing your debt can help you work toward paying it down and investing. If you have student loans or a mortgage, for instance, you might refinance those loans to lock in a lower interest rate. A lower rate could mean a smaller monthly payment. That may leave you more money to pay toward the principal and reduce future interest payments.
With credit cards, a balance transfer or debt consolidation loan might be an option. A 0% APR balance transfer offer, for instance, could give you a set number of months to repay credit card debt with no interest. Debt consolidation loans can also allow you to combine multiple card balances at a single low rate.
When You Can Only Pay Off Debt or Invest
If your budget won’t allow you to pay off debt and invest at the same time, take a step back and consider your overall financial situation to decide which one makes more sense. Advisors say it’s helpful to consider your risk tolerance and the interest rates you’re paying on debt in making the decision.
For example, if you have a loan or credit card with a low interest rate, you can wait to pay off that debt. Instead, that money can be invested and earn more money faster than interest accumulates. That said, high interest rates that outpace potential returns are a strong argument for paying debt first.
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.
Ideally, you’re able to position yourself financially to do both. If you can’t, consider which one’s going to offer the best return for your money, now and later.
Tips for Managing Debt and Investing
- Talk to your financial advisor about the best investment strategy for you, based on your age, risk tolerance and overall goals. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- If you’re working on paying down debt while also investing, make sure you’re investing your money in the right places. Take time to compare different online brokerage accounts, for example, to see the range of investment options and the fees they charge. And of course, make sure you’re taking advantage of opportunities to invest on the job. If your employer offers a 401(k) or similar plan, make sure you’re contributing enough each year to get the full employer match if one is offered.
Photo credit: ©iStock.com/Kritchanut, ©iStock.com/ipopba, ©iStock.com/oatawa