It’s a dilemma that many people face when they start taking their personal finances seriously: should I pay off debt or start investing? The simple answer is: it depends. But that’s not very helpful, is it? So let’s dig deeper. We’re going to break down the pros and cons of both strategies, so by the end, you’ll have a better idea of what’s right for your situation.
The Case for Paying Off Debt First
First, let’s talk about why paying off debt is often the go-to strategy for many financial advisors. Debt can be a huge burden, especially if it’s high-interest debt, like credit card balances. Here’s why focusing on eliminating debt might be the right move for you.
1. High-Interest Debt Eats Your Money
One of the biggest reasons to pay off debt first is the sheer cost of carrying it. Credit card debt, for example, often comes with interest rates of 18%, 20%, or even higher. Now, think about how much you’d need to earn in the stock market to simply break even with that kind of debt. It’s tough, even in a strong market.
For every dollar you pay toward your debt, you’re saving on future interest costs. It’s almost like getting a guaranteed return on your money. No matter how much the stock market grows, it’s unlikely to consistently beat the cost of high-interest debt over time.
2. Psychological Wins and Peace of Mind
When you pay off debt, you’re not just freeing up your budget; you’re also gaining a sense of emotional freedom. Carrying around debt can be stressful. You constantly have that looming monthly payment hanging over your head, and it can feel like you’re working for nothing.
Paying off debt gives you a sense of accomplishment. It’s one less thing to worry about, and that can go a long way for your mental health. Plus, once you’re debt-free, any money you earn can go directly toward building wealth, instead of just managing your obligations.
3. Cash Flow Boost
Once your debts are paid off, that’s extra money you don’t have to allocate toward monthly payments. This increase in cash flow can then be redirected toward saving and investing, allowing you to grow your money without the drag of interest payments.
4. Financial Flexibility
Being debt-free gives you financial flexibility. It’s easier to handle unexpected expenses without going into further debt, and you’re in a much stronger position to take advantage of financial opportunities when they arise.
The Case for Investing First
On the other hand, investing while still carrying some debt might actually make sense in certain scenarios. This strategy can work for those who have lower-interest debt, like student loans or a mortgage, where the interest rates are relatively manageable.
1. Compound Interest is Your Friend
The biggest advantage of investing early is that you give your money time to grow, thanks to compound interest. The longer you leave your money invested, the more it has the potential to grow exponentially. The earlier you start, the more you can benefit.
Let’s say you’re in your late 20s or early 30s. If you wait until you’re completely debt-free before you start investing, you could miss out on years of potential growth. Time in the market is often more important than timing the market.
2. Low-Interest Debt
If your debt has a relatively low interest rate—let’s say around 3-5%—it may make more sense to prioritize investing. Historically, the stock market has returned an average of about 7-8% per year. While nothing is guaranteed, the long-term potential of investing can outpace the cost of low-interest debt, making it a smart move to start building wealth even while you’re still carrying some debt.
3. Employer Matching Programs
If your employer offers a 401(k) match, not taking advantage of that is essentially leaving free money on the table. Even if you’re carrying debt, contributing enough to your retirement plan to get the full match is almost always a smart financial move. The return on investment here is immediate and guaranteed.
4. Diversification of Financial Goals
Paying off debt is great, but if that’s your sole focus, you could be missing out on other important financial goals. Investing for retirement, saving for a house, or even putting money away for a child’s education are all goals that require time and consistent contributions. By balancing debt repayment and investing, you can work toward multiple objectives at the same time, without putting everything on hold for the sake of becoming debt-free.
When to Pay Off Debt First
So, when does it make sense to aggressively tackle debt before investing? Here are a few situations where that approach might be best:
1. High-Interest Debt
If you have credit card debt or personal loans with an interest rate above 8-10%, paying those off should be your top priority. The returns from investing are unlikely to outpace the cost of carrying this kind of debt, so eliminating it is the best way to improve your financial situation.
2. Variable Income or Financial Insecurity
If your income fluctuates (freelancers, gig workers, etc.) or you don’t have a solid emergency fund, focusing on paying off debt can give you more breathing room. When times are tough, not having to worry about debt payments can make a huge difference.
3. Psychological Burden
For some, the emotional weight of debt is simply too much to bear. If carrying debt is causing significant stress or anxiety, then focusing on paying it off might be worth it—even if, on paper, it would make more sense to invest. Personal finance is more than just numbers; it’s about your well-being too.
When to Invest First
Now, let’s flip the script. When might it make more sense to focus on investing while still carrying some debt?
1. Low-Interest Debt
If your debt is primarily student loans or a mortgage with interest rates below 5%, there’s a good argument for focusing on investing while making minimum debt payments. The potential returns from investing could easily outpace the cost of carrying this kind of debt.
2. Employer Retirement Match
As mentioned earlier, if your employer offers a 401(k) match, contribute enough to get the full match. It’s free money, and you don’t want to miss out.
3. Long-Term Financial Goals
If you have long-term goals like retirement or buying a house, it can make sense to start investing early, even if you have debt. This is especially true for younger individuals, who have more time for their investments to grow.
4. Emergency Fund in Place
If you already have a solid emergency fund (usually 3-6 months of living expenses), you might feel more comfortable investing knowing you have a financial safety net in place. If an unexpected expense arises, you won’t have to rely on high-interest debt to cover it.
A Balanced Approach: The Best of Both Worlds
Often, the smartest strategy is a balanced one. You don’t have to be all-in on debt repayment or all-in on investing. Here’s how a hybrid strategy could work:
- Pay off High-Interest Debt
If you have high-interest debt (above 7-8%), focus on paying that off aggressively. At the same time, contribute a small amount to your employer’s 401(k) plan or an IRA to take advantage of any match or tax benefits. - Start Investing Early
Once your high-interest debt is under control, start investing more heavily. You could still carry some low-interest debt, but the goal is to balance paying off that debt with growing your investments. - Emergency Fund Comes First
Before aggressively paying down debt or investing, make sure you have an emergency fund in place. This fund will help you avoid accumulating more debt if something unexpected happens. - Reassess Regularly
Your financial situation will change over time. Every few months, check in with your budget and financial goals. Maybe you’ve paid off enough debt that it’s time to shift more focus toward investing. Or, perhaps you’ve had a financial setback and need to go back to focusing on debt for a while. Flexibility is key.
So, What’s Right for You?
Ultimately, the answer to the “pay off debt or invest” question depends on your personal financial situation. Here’s a quick way to help guide your decision:
- If you have high-interest debt, pay that off first.
- If your debt is low-interest and you have access to an employer’s retirement match, start investing.
- If the emotional weight of debt is too much, focus on becoming debt-free.
- If you have an emergency fund and are comfortable with your debt, consider investing to take advantage of compound interest.
At the end of the day, the best financial decision is the one that helps you sleep better at night. Whether you choose to focus on paying off debt or investing, know that both are steps in the right direction toward a healthier financial future.