Should You Pay Off Your Debt or Invest?
The Answer: It's Complicated
For those with extra cash on hand, it may be difficult to decide whether to put that money toward paying off debt or investing. Both are admirable pursuits and necessary aspects of financial responsibility.
Paying off your debt means reduced stress, lower risks, and a greater ability to withstand personal emergencies, recessions, and depressions. Investing means building a reserve that can protect you and your family, provide you with passive income, and allow you to retire comfortably.
Both of these pursuits are worthwhile, so how do you choose between them? Here are some factors and thoughts to keep in mind as you decide what's best for you.
Quantifying Paying Off Debt vs. Investing
As you begin considering your options, using a calculation to quantify the benefits of both paths can help to put things in perspective. Start by comparing these two variables:
- The rate of after-tax interest you are paying on your debt
- The after-tax rate of return you expect to earn on your investment
If you can earn a higher return on your investments than the interest on your debt, you should invest. On the other hand, if you're carrying high-interest debt such as credit card debt, it may make more sense to pay off your balance.
For example, billionaire investor Warren Buffett told CNBC that he took out a mortgage on a home he bought in 1971. Despite likely having the cash on hand to purchase the home outright, he estimates that he only put down roughly 20% of the house's price at the time, and he got a mortgage to cover the rest of the cost. He presumably knew he could put his money to work elsewhere in his investment portfolio, rather than spend it all at once on a home.
As you calculate your potential returns from investing, don't forget to consider risk-adjustment. There are a lot of unknowns with investing, and you must account for those risks to accurately compare potential benefits.
A Potential Hierarchy
Your goal should be to both invest and pay off your debt, but a hierarchy might help you decide when to put money toward each cause. The following order is meant to achieve these goals:
- Minimize your tax bill, which means more money in your own pocket
- Create significant bankruptcy protection for your retirement assets
- Reduce your debts over time until they're entirely repaid
- Save riskier investments in taxable accounts until after all of your other basic needs are met (for example, if you have a lot of debt and a small retirement account, you probably shouldn't be investing in IPOs)
Work-Sponsored Retirement Plans
Fund any retirement account you and your spouse have at work, such as a 401(k) plan, up to the amount of free matching money you receive. Many employers offer matching contributions, though there may be stipulations on how much they're willing to match. Learn the limits and maximize your benefits.
Next, build your emergency fund in a high-interest savings or money market account. It may seem counterintuitive to save cash when you're trying to pay off debt, but having an emergency fund can help you avoid worsening your debt as you work to eliminate it. A common rule of thumb for how much to save is between three and six months' worth of expenses, but any amount will help.
If you meet the eligibility guidelines, fully fund a Roth IRA. These retirement accounts allow savings to grow tax-free. Roth IRAs have contribution limits, which are partially determined by your income level. If you are eligible, you should try to maximize your contributions.
After you've put some money toward retirement and emergency funds, shift your focus to high-interest credit card debt, student loan debt, or other liabilities. You can start with the debt that is most difficult to discharge during bankruptcy, such as student loan debt, and then work your way through your outstanding balances. Keep at it until you are debt-free—and stop adding to it so you don't build it back up.
Other Retirement Savings
Now that your debt has been handled, circle back around and top off any retirement accounts by maximizing your contributions up to the limits. Tax regulations and company policies will affect your contribution limits. You may consider using a Health Savings Account (HSA) as another retirement-focused savings vehicle.
If applicable, this may also be a good time to consider funding a college 529 savings plan for your children or grandchildren.
After you're debt-free and have hit your retirement contribution limits for the year, begin building assets in fully taxable brokerage accounts, dividend reinvestment plans, directly held mutual fund accounts, and other cash-generating investment assets. For example, a real estate investor could purchase apartment buildings, office buildings, or industrial warehouses.
Another Approach: Focus on Debt
The order above offers a balanced approach to investing while paying down debt, but it isn't the only way to approach this issue. There are a lot of benefits to focusing all your effort on debt, especially if you have a substantial amount you need to pay off.
A major advantage of focusing on debt is that it allows you to protect your assets—if you don't have debt, assets can't be taken away as a collateral payment or as part of a bankruptcy settlement. Your money may not have as much time to grow in an investment account, but once you've paid off your debt, you can put all your spare cash toward investments and quickly grow your savings.
The Bottom Line
Behavioral economics need to be factored into your decision—you and your financial situation are the variables that matter most. If debt stresses you out or you have a significant outstanding balance, put all your effort toward eliminating it. On the other hand, if you only have a small amount of debt subject to low interest rates, it might make more sense for you to let that debt linger for a while and build up your savings.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
CNBC. "Here's Why Warren Buffett Thinks You Should Buy a Home." Accessed May 27, 2020.
Internal Revenue Service. "Amount of Roth IRA Contributions You Can Make for 2020." Accessed May 27, 2020.