Should you invest or pay off debt?
Everyone’s financial situation is different and there is no one-size-fits-all strategy. My answer for whether you should invest or pay off debt depends on several factors.
Generally speaking, your ideal financial situation would be as follows:
- No debt
- Live below your means
- Accumulate a 6-month emergency fund
- Invest as much as you can (max out your IRA, 401(k), HSA, 529 Plan, etc.), then start pouring money into taxable brokerage accounts.
If you are not in the “ideal financial situation” boat, that is ok, it is something to work towards. In fact, most people lie somewhere between “ideal financial situation” and “drowning in debt”.
Do you have a 6 month emergency fund? Before you start investing and before you start really paying down debt, you need to make sure you have a 6 month emergency fund in place. The amount should be 6 months of your basic living expenses (rent/mortgage, food, insurance).
What happens if you lose your job? What happens if you have an accident that requires a lot of medical care and you are out of work?
Hope for the best but prepare for the worst. An emergency fund will save you if you find yourself in a tight squeeze.
If you have the ability to contribute to a 401(k) with an employer match, the minimum you should be investing is the amount of your employer match.
For instance, if you employer matches up to 6%, you should be saving from each paycheck 6% of your salary. An employer contribution is part of your salary. If you do not contribute up to the employer match, you are voluntarily telling your employer you do not want to be paid a portion of your salary.
It is very hard to persuade me that putting away less than your employer match is a good idea.
When it comes retirement planning my rule of thumb is this:
- Before paying off debt, save up to your employer match in your 401k or other employer sponsored retirement plan.
When you are trying to figure out whether to pay off debt or invest – the second thing you need to keep in mind are the minimum payments.
Minimum Payments are not optional – you must pay them every month. If you do not pay the minimum, then your credit score is going to suffer because your payment history (35% of your total credit score) is going to have blemishes on it.
Before you start investing, make sure the minimum payments on all debt are paid on time.
Interest rates play an important role in deciding if you should invest or pay off debt.
If the interest rate on your debt is 4% or lower, take your time paying off the debt – no real rush. You can make more money if you invest appropriately.
If the interest rate on your debt is over 4% then pay it off before you start investing. Debt with high interest rates will end up costing you a lot more than you are likely to make by investing that money.
Below is a chart of the average interest rate for common types of debt.
Debt is emotionally draining. It hangs over your head and lingers in the back of your mind constantly. Regardless of the interest rate, debt limits your options – you are required to pay it back. No matter what the math tells you, being free from debt feels good.
Mathematically speaking, if you can make more money investing than the interest rate you are charged, then investing is the better option.
Mentally speaking, if you feel trapped – paying off your debt first is the better option.
Do not disregard your feelings. Mental health is important and it is really important to know yourself and figure out whether paying off debt is going to make you feel a lot better.