Pay Off Debt Or Invest? The Never-Ending Question

One of the never-ending questions of the personal finance world is whether you should pay off debt or invest. There are lots of reasons to do so on both sides of the argument. The important thing though, is to find your side and what will work best for you. Do you pay off debt or invest first?

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Should I Pay Off Debt Or Invest Extra Funds?

In 2012 we were faced with this exact question. I received a bonus and a raise and felt that I was finally in position to make some financial moves. My wife and I added up our debt and saw that we were $107K in debt. We knew it was a lot but didn’t know it was that much!

That day we also discussed what our future goals were. One big goal was to have kids in the future. The other big goal my wife wanted was to be a stay at home Mom once we had kids. At the time, we both worked so her staying at home would be a big deal considering we needed both incomes to cover our bills and debt payments.

You can see where this is going. The numbers forced us into both working but it isn’t just about the numbers. It is about our personal goals and using money as a tool to help us get there.

On that day, we decided to pay off our debt. 33 months later we were debt free. I’ll get into more details later such as whether we invested at all during our debt payoff, or whether we regret our decision, but let’s focus on your situation right now.

Get Your Financial House In Order

The good news is that if you are asking this question you are doing something right. You either want to reduce your liabilities or grow your wealth. In a way, it is a question with a win-win answer.

One of the guarantees in personal finance is that if you spend less than you earn you will come out on top. This is basically the question of what to do with that extra money.

Be sure to have a budget in place and track your spending during this process. This will help you get the most out of your hard-earned money.

Do You Have An Emergency Fund?

Before you pay off debt or invest, you must have an emergency fund. This is critical so that you don’t go into more debt if an emergency occurs. If you don’t have an emergency fund then you need to prioritize that first.

The good news is that the lessons that you learn while building your emergency fund can be directly applied to paying down debt and investing. Also, you are building your net worth by building an emergency fund which is really the big goal with all of this.

Keep in mind though, this is an emergency fund, not a fund to invest with or pay down debt with later. The emergency fund is just that. Money dedicated to emergencies.

Where Do You Keep Your Emergency Fund?

The best place to keep an emergency fund is in a high interest savings account that is FDIC insured. Nowadays, that is basically an online account that pays around 1.5% although that varies according to the market and the bank.

Don’t keep it in a traditional bank savings account because that basically earns nothing. Stick with the online account at about 1.5%, also known as a money market account.

How Much Should Be In Your Emergency Fund?

There are 2 golden rules for how much should be in your emergency fund.

Have at least an $1,000 emergency fund.
Have 3-6 months of expenses in your emergency fund.

This is where you will have to start making decisions about what is best for you. If you are young, healthy and single then $1,000 is most likely OK. If you are older, with a house and family, having 3-6 months of expenses is nice to have.

If you have never even had $1,000 in your life then start with that regardless of your situation. Honestly, if you have never had $1,000 in your life then and I might suggest that paying off debt should be your priority but keep reading to help determine what is best for you.

Do not ignore this step. Emergency funds set you up so that you can have financial success down the road. Many households in the US don’t even have $1,000 in savings. That means they are on the brink of financial ruin at any moment.

The emergency fund is the number one defense against going into further debt.

The Math Behind Paying Off Debt or Investing

One of the greatest motivating factors for us when paying off our debt was understanding the numbers. By understanding the numbers, we felt like we had total control over our situation.

You want to both understand the numbers on the debt side and the investing side.

What are your interest rates on your debt?
What interest rate does the investment earn?
What are your minimum payments on the debt?
How much interest will you pay over the life of the loan?
How much money will you make from your investment?
How much extra do you have per month in your budget to invest or pay off debt?
How does each decision affect your budget?
When are you currently scheduled to pay off your debt if you just pay the minimum payments?
Can you live off one salary with your debt payments?
What size emergency fund do you have?
Will you have other liquid cash as an asset?
Does the investment add a minimum payment?

It isn’t just about the interest rate you are paying or could earn, it is about all the numbers. From your budget, to periods of time, to extra cash reserves you need to evaluate your whole situation.

I developed a tool that will help you answer a lot of these questions. This amortization schedule calculator will tell you how much interest you will pay over the life of debt you have. It also will show you each payment you are to make and its scheduled payoff date. For paying it down early it will show you how much money and time you can save.

Additionally, learn how to calculate interest on a loan to really get in to depth.

Interest Rates

The interest rates involved on the debt and the investment will give you a general idea of which direction to go if you are just focusing on the math.

The thing to first realize is that if you are paying off a loan that is charged 7% of interest, any extra amount you pay will essentially return you 7%. It also means that as you pay more you will be done sooner, increasing your cash flow, but I don’t want to get ahead of myself.

In Favor of Debt Payoff

One of the general rules to use when comparing debt vs. investments is to compare the interest rates. If your debt is charging you 25% and the investment will pay you 10% then you should favor paying off the debt since you will get a 25% return on your money.

In Favor of Investing

If your debt is charging you 2% and your investment is paying you 10%, then it makes sense to consider the investment. Notice I don’t say to automatically go out and invest that money. We still need to look at other factors. The answer is obvious from a math perspective that you will make 8% more money with the investment.

When It Is Not So Clear

Now, let’s say your debt is charged 5% of interest and your investment will pay a return of 6-7%. Technically, you will make more by investing that money, but, is that what is best for you?

Is it worth it to you to invest that money while keeping the debt payments going? This is where it becomes more of a judgement call and you will definitely need to factor in other aspects.

If it was me, I would just pay it off. Our loans were between 4.75% and 7.75%. Typically, stock market returns are expected at 6-8%. The benefit was that by paying off our loans we increased our cash flow not only once we were done but during the process.

How Cash Flow Factors In

Cash Flow is basically the amount of money coming and going in your monthly budget. If you have $5,000 a month coming in and have $4,500 of expenditures, including your minimum payments, you have $500 left over to do what you want with it.

If your debt payments are $750 of that and you pay off your debt you will now only have $3,750 of expenditures per month with $1,250 left over. By paying off your debt, you increased your cash flow.

When investing your money, instead of paying off debt early, you are keeping your cash flow tighter. Are you OK with that? What if a member of the household loses their job? Do you need that cash flow in the future?

For us, we needed to reduce our expenditures so that we could live off one salary. That difference in cash flow meant a drastic change for our household and family.

It Is More Than Just The Math

The math is the math. In many ways, it is fair when so many things in life don’t feel fair. 1 + 1 is 2 for everyone.

Now, the math should be a factor, but it should not be the deciding factor unless everything else is equal. The deciding factor is your current situation balanced with your future goals.

Write out your future goals and talk them over with your spouse if you are married. If you are married then you need to factor in both opinions about what to do.

If you invest the money and the other person is against it is it worth it?

What Is Your Risk Tolerance?

Basically, how well will you sleep at night with debt or without debt?

Paying off debt is the more conservative thing to do certainly but that doesn’t make you weak. It might make you more willing to take risk in the future since you have less obligations. That is something to consider. As you go through your life your risk tolerance will adjust depending on your situation.

If you decide to invest the money you will also have a decision about how risky you want the investment to be. What is the downside of it? What is the upside? If you lose it all are you OK with that?

Often times, in the cases where one pays off a low interest rate such as 2% instead of investing the money, those people are accused of being too emotional.

You should also ask yourself the same. Are you being too emotional with the investment? Is the potential payoff huge, but ultimately a big risk? Investments are not a guarantee.

You should make sure you aren’t being emotional on either side. At least with the debt though you lock in a guaranteed returned of whatever interest rate you have.

What Type of Debt Do You Have?

Not all debts are created equal. Here are the typical types of debt

Credit Card
Student Loans
Car
Medical
Mortgage
Rental Property

The type of debt you have plays a role in your decision. It is important to understand the difference behind credit card debt and a mortgage. Most likely, you have multiple types of debt and the debt that you do decide to pay off you will want to lump together. In the meantime though, let’s review each type and whether you should pay it off.

For us personally, we had student loans and a car loan and we paid both off as part of our $107K payoff. I also had past experience with credit card debt so I am familiar with most of these.

Pay Off Credit Card Debt Or Invest?

Credit card debt is typically the highest interest debt that you can have. A typical credit card interest rate might be 18-25%. You’d be hard pressed to find investments that can beat a credit card. Even if you can find a return that is better than 25%, credit card debt can be insidious and a revolving door that never ends.

My advice is to get rid of all credit card debt before investing. The exception you can look into is with your 401K and the employer match but that is not always a guarantee.

Pay Off Student Loans Or Invest?

Student loans have lower interest rates than credit cards but they are usually in the 4-8% range. Some are as low as 2% but that isn’t as typical. Knowing that most investors project 6-8% for stock market returns you can see this is that middle zone where there is little benefit to investing.

Additionally, student loan balances are constantly increasing. The average student loan balance when getting out of school is $30K-$40K. It isn’t uncommon though to see people with $150K of student loans.

That amount of debt can be crippling. If your debt is a strain on your monthly budget then you need to get rid of it. Even if it isn’t crippling to you, you can still find plenty of reasons to pay it off.

Federal student loans can’t be easily bankrupted so there is no easy way out of them. There are various federal programs that include loan forgiveness but be careful. There are many qualifications and restrictions that may not be in your best interest depending on your situation.

My personal suggestion is to get rid of them. It may not always be advantageous from an interest rate standpoint, but once it is paid off I don’t think you’ll want it back.

Pay Off Car Loans Or Invest?

Car debt can be tough depending on whether you bought a new or used car.

The general practice for keeping automobile costs low over your lifetime is to always buy used and pay cash for the vehicle. The main reason being that if you buy new, the car loses lots of value the moment you drive it off the lot.

Car loans can be as cheap as 1.9% but they typically are 4-6%. The average vehicle loan is $31,453 with a whopping monthly payment of $523 according to this USA Today article. A payment like that sounds like it could hurt your cash flow and limit your opportunities to invest.

While a car has value, it is not an investment. The average car does not go up in value. It goes down over time. So, while you can sell it, it might not be worth as much as your loan. This is also called being underwater and many people get stuck in this trap.

My suggestion is to pay off the car loan and save up cash for your next car. That amount paid would not come from your emergency fund, but rather a sinking fund. Getting out of the cycle of always having a car payment is a great position to be in and it increases your future investing opportunities. So, while you maybe have a loan at 2%, you really want to position yourself for long term success by eliminating that monthly car payment altogether.

Finding the right car and holding onto it for a long time is a great way to reduce your car expenses and in turn, build wealth.

Pay Off Medical Debt Or Invest?

Medical debt is different from credit card debt or student loans in that you didn’t plan to take on the debt. They were most likely incurred due to a medical emergency, long term illness or an accident. Maybe insurance only covered so much leaving you stuck with the rest of the bill. There is also no asset or value behind it.

Either way, it is dangerous since it appears to be the leading type of debt associated with bankruptcies. When I see that I know that it needs to be taken seriously.

Something like that sounds like it needs to be dealt with as soon as possible. Hospitals can work with you to set up payment plans but do not treat it lightly.

To avoid medical debt in the first place this is where having insurance is key, but that is what the emergency fund is for as well. You need to be able to pay your deductible so that is something to consider when establishing your emergency fund.

Pay Off Mortgage Early Or Invest?

OK, now we are getting to something that makes sense to be investing first. Going back to interest rates, mortgage interest rates are at historical lows these last few years. Refinance your mortgage if it is higher than 5%. Most rates are less than 4% nowadays so there is more of a spread when looking at the profit you can make.

Additionally, and this is the most critical, your house is an asset that has inherent value. You can sell it for a profit in the right market. You can also sell it and take a loss depending on the state of the economy but it still has value. The difference between what you owe and its value is your loss or profit.

If you owe $150K on your mortgage but your house is worth $180K then your house will pay off the mortgage once sold. That is much different than having $150K of student loan debt that has no backing asset like a house.

Real estate, if done right, is a great way to make money if you buy at the right time. You always need housing, so don’t look at it as a straight investment, but there are enough success stories to know that you can make money on your primary residence over time. Watch that lifestyle creep though!

Personally, we want to pay off our house early, but we are prioritizing investing to get that money generating interest. I’m not sure when we will pay it off. We are 2 years into our 30-year mortgage, but not having a house payment is the long-term goal. It may not make sense from a purely mathematical approach, but it does offer more freedom.

Pay Off 2^nd Mortgage Early Or Invest?

Now, let’s look at rental properties. This is a real judgment call depending on your situation. If you have a dedicated emergency fund for your rental property and are making a profit every month then there is a good reason to keep that mortgage around. Basically, let the tenants pay it down and put your money elsewhere.

If you have a 2^nd house in another state that you never intended to be a rental property, barely breaks even, and is a nightmare to deal with, get rid of it. It isn’t making your life any easier so dump it.

There is probably a spectrum in between that you might fit in. Figure out what role this property plays in your future. Do you like the risk of it? Will it provide passive income in the future? These are some questions to ask to help you determine the route to go.

If it is profitable, then you can still pay down the mortgage if it makes you sleep better. It will reduce your risk on the property in case you lose a tenant but it is less critical.

I think another long-term goal though should be to own your rental properties outright though. Maybe pay it off later in the loan but there are probably better thing to prioritize now.

What Are You Investing In?

Just like the debt, not all investments are created equal. You won’t see an immediate return in your pocket from your investment most likely. Also, while you are investing, you are still making your debt payments. You need to review your budget to be sure you can do both.

Some investments also have tax advantages that you need to factor in. I’ll review the most common types of investments to help you determine how you should prioritize them in relation to your debt.

These investments include the following.

401K
Roth 401K
IRA
Roth IRA
Brokerage Account
Real Estate
BitCoin

Pay Off Debt Or Invest in 401K?

The common wisdom regarding 401Ks is to invest up to the company match. The company match is free money. If you don’t invest it, you don’t get the match. This is basically a 100% return on your money. Paying off your debt might mean a 2-25% return but this is a 100% return. Think about that.

A traditional 401K has tax benefits to consider. Any amount of money you put in is paid with pre-tax dollars. You only pay taxes on that money and any earnings when you withdrawal during retirement.

By paying with pre-tax dollars you lower your tax liability. The benefit is that by lowering your tax liability you are potentially lowering yourself from one tax bracket to another. Certainly, something to consider.

Keep in mind that you will not have access to the money until you are at least 59 ½ years old. There is something called the Roth Conversion Ladder though that early retirees can use if you do want to access it prior to 59 ½ without penalty. Pulling money out before 59 ½ will otherwise result in a 10% penalty.

It is great to invest in your 401K now to get that compound interest working for you as soon as possible. Any money you have above and beyond the company match should go toward paying off debt. Once you are debt free, then ramp up your 401K contributions.

So, why would you not invest up to the match? Well, what if you have no extra money to invest and pay off debt? One can make an argument to stop 401K contributions and to knock out the debt and get some breathing room. You don’t want to do this for too long though, but it might just be what you need to jumpstart things.

Pay Off Debt Or Invest In A Roth 401K?

A Roth 401K is funded with post tax dollars. Basically, money that you receive in your paycheck after taxes have been taken out. This mean that you have already paid taxes on the initial contribution. The fun part is that you don’t have to pay taxes on any earnings that accrue. That’s right, you get to withdrawal all that money tax free.

Now, keep in mind that any company match you get is most likely funded with pre-tax dollars. You have no choice in that. This means that any earnings you receive off the company match portion will be taxed at withdrawal. This would need to be verified with your employer though.

Like the traditional 401K, if you can, invest up to the company match and take any extra money and pay off your debt. Then you can come back and invest more once debt free.

Consider This If Investing In Your 401K – Are You Vested?

Typically, the company match is not yours immediately. Company matches must vest. Vesting is a system that is determined based on how long you have been with the company.

There are 2 ways vesting works. This is determined by your company. You have no say in it.

You work at your company for 3 years and you are then 100% vested.
You work at you company for 6 years and you are then 100%.

For the second option you do become vested along the way as follows.

Year 2 – 20% vested

Year 3 – 40% vested

Year 4 – 60% vested

Year 5 – 80% vested

Year 6 – 100% vested

If you leave any time before you are vested either 20% or 100% in option 1 you don’t get any of that money. You still get the amount you contributed though as you should. If you leave prior to year 6 in option 2 then you only get the percentage associated with your time in the company.

If you don’t plan on working at your company long, you may not get any of that money, but you will still have that debt hanging around.

Pay attention to the vesting. Is your job stable?

Pay Off Debt Or Invest In An IRA?

An IRA is an Individual Retirement Account. It is like your 401K, in that it is dedicated to retirement and has tax advantages. Unlike the 401K though, it is not through your company so there is no company match. It is entirely self-funded.

It is an account that you open on your own. If you don’t know where to start, go with Vanguard for a low-cost solution and focus on index funds.

You are limited to $5,500 per year that you can contribute so it isn’t a big investment.

An IRA is funded with pre-tax dollars and just like the traditional 401K, it lowers your tax liability. You pay taxes on both the initial investment and the earnings upon withdrawal.

Since there is no match, it is easy to argue to pay off the debt first. The reason to invest though is to get that money working for you now rather and take advantage of compound interest.

Pay Off Debt Or Invest In A Roth IRA?

A Roth IRA is like the IRA, except it is funded with post tax dollars. You are also limited to $5,500 per year that you can contribute. Keep in mind though, you have already paid taxes on those dollars.

Any earnings you make are tax free upon withdrawal.

Just like the traditional IRA, it is not associated with your place of employment so there is no match. With that, just like the IRA, it makes sense to get rid of debt unless you are adamant that you need your money working to build that compound interest.

Pay Off Debt Or Invest In A Brokerage Account?

A brokerage account is basically a regular investment account. It is not a retirement account. There are no tax benefits. You can purchase stocks, bonds, mutual or index funds, etc. in it.

If you want to buy Apple or Google, this is where you would do it. You can sell your investments at anytime. Any profit will be taxed as a capital gain. Any profit left over is yours to do with what you want. The benefit is that you don’t have to wait until a certain age to pull it out. Any profits that you get can go directly to more investments or maybe to pay off debt.

The downside is that if your investment goes down you will either sell at a loss or have to wait until it goes up. That means that you might have been better off having paid off your debt anyways.

If it goes up, well, you won. But, what are you going to do with it? How does it work into your long-term future?

Pay Off Debt Or Invest In Real Estate?

Real estate can be a lucrative investment if done right. This is not a real estate guide, but if you are able to buy low and sell high or earn positive passive income then you will be in great shape. The key is to be smart from the very beginning of your investment.

Do you have a dedicated emergency fund to cover unexpected expenses? Can you cover a few months with a renter? Did you buy it for less than its true value?

If you answer yes to those, you are in great shape. If you can fix household items yourself or find trustworthy renters you are in better shape.

Real estate is not for everyone though. Even if it is for you, does it make sense to start investing in real estate if you have $80K of debt? Seems like it would be better to get rid of that before investing to lower your risk.

Or, maybe you just have a few thousand dollars of debt. While it is most likely completely manageable, why not just get rid of it? How much do you really stand to gain on $2,000 at 2% of returns?

Real estate can be a great investment but you will be more successful if your other finances are in good shape. Don’t get too emotional about a ‘hot’ deal. Think through it rationally to determine the best course of action for you.

Pay Off Debt Or Invest In Bitcoin?

Bitcoin is a controversial topic. I don’t want to get into that, but looking at its history, it isn’t the most predictable investment. It is a technology essentially, but there is no physical asset behind it. Due to its volatility you are essentially gambling with your money. It is extremely risky.

If Bitcoin is for you then please consider these words of a Bitcoin Millionaire. He doesn’t recommend purchasing Bitcoin, but if you do he has very specific instructions that I agree should be followed.

Paying off debt is the clear winner for me here. Pretty much all other investments previously discussed are better to make if you are going to invest before paying off debt.

Did We Invest While Paying Off Debt?

Yes.

We invested in my wife’s 401K up to the company match. It wasn’t much. Her company only matched $500 per year. While that is very low, they also had a profit sharing program that vested at 100%. It was basically a bonus that was contributed to your retirement fund.

The company I worked for didn’t have a 401K for me to invest in. My wife 401K was the only investing we did while paying off debt.

Do We Regret Paying Off Our Debt Instead Of Investing More?

No.

Mathematically, we could have been more optimized by investing, but the freedom it has given us cannot be quantified. Having my wife stay at home with our kids has changed our lives. While there are challenges with that, we wouldn’t change it at all.

Being debt free has allowed us to be more aggressive with the amount we save as well as risk we can take. Less obligations means we have less monthly payments to make.

It is certainly a situation I want you to be in.

Paying Off Debt Is Best Investment

Here’s the thing, I want you to be debt free so that you can invest 20%, 30%, 50% or 75% of your income. Being debt free gives you the most flexibility going forward. Keeping debt around, while it might make mathematical sense sometimes, means you have already determined where those dollars go.

Debt is a commitment to where you are going to spend your future dollars. That means less flexibility in the future.

One thing to know is that focusing on debt first doesn’t mean you will never invest. It just means that while you wait to invest, you will have more money to invest when the moment arrives.

How To Prioritize Your Debt?

If you are going to focus on your debt I suggest following these 6 simple steps to get out of debt. This will help you to prioritize which loans to pay off first.

It is a comprehensive guide to examining your finances and tackling your debt. The concepts are simple but there is a lot of information in there to help you along the way.

Is the debt snowball method or the debt avalanche method better for you? This guide will help you determine that.

Track your progress using this free debt thermometer to keep you motivated during your debt payoff.

Is it Just About the Math?

No.

With that said, the math should absolutely be considered. It should be understood on both the debt side and the investment side.

Life is more than math though. You need to examine your goals, who you are and what works best for you. It is your life and no one will pay more attention to your money than you.

Listen To Your Gut

One reason why it isn’t always about the math is that you might just have a funny feeling about something.

If your gut is telling you to get rid of that debt, then do it.

If it is telling you that you need to focus on investing, then find the best possible way to invest.

Can you do both at the same time and stay focused? That is a great solution if you can stay motivated.

Just because one solution works for someone else doesn’t mean it works for you. Now, you should consider the input of other people, but you have to know yourself.

What To Do When All Of The Debt Is Paid Off

Once you are done paying off the debt you need to invest it.

Take all the money you were throwing at debt and put it towards investments. A great place to start is with those tax advantaged retirement accounts. Depending on your current tax situation, the Roth or traditional accounts will benefit you. I like to have a mix of both as we never know what taxes will be once retired.

Continue to live on a budget and watch your expenses. This doesn’t mean deprive yourself, it means to find ways to get the most of out the dollars you spend.

Build your life the way you want to live it. Have your investments support you in this process.