If you’ve got some extra money lying around, should you invest it, or use it to pay off debt?
A few weeks ago a friend of mine asked me this question after receiving a bonus at work. And we usually get an influx of the same question from readers across the globe around tax time when refund checks start rolling in. The crux of the matter is always this: should you focus on investing or paying down debt?
In this post, we’ll dissect the pros and cons of both options and equip you with the knowledge to make the best decision for your situation.
Of course, either decision will help you progress. They’re both better options than spending those additional dollars. So no matter what you choose, congratulations! You are already moving in the right direction. 😉
First, let’s talk about interest…
Investing and paying off debt can both heavily impact your finances because of interest.
Interest can be a blessing or a curse. If you owe money, you pay interest. When you invest money, you earn interest.
Paying off debt and ridding yourself of negative interest is always a good goal. But investing is also a crucial goal because any dollars you opt to invest can help grow more money over the years! So which is more important?
When deciding whether to invest or pay off debt with a lump sum of money, you might start out by comparing the potential impact of interest in both scenarios. Interest earned (if money was invested) vs. interest saved (if debt was paid down).
For example, let’s say you have a lingering credit card debt from buying a new couch that was $2,000. And let’s say your credit card interest rate is 22%. If you pay off that $2,000 debt in one fell swoop, you’ll save about $246 in would-be interest compared to making debt payments for a year.
On the flip side, let’s say you save that $2,000 in a high-yield savings account. The best savings accounts pay about 5% interest right now, which means that over the course of a year you would earn about $100 in interest based on that choice.
What’s the better financial move? Pay off the credit card debt and save $246 in would-be interest, or invest in a HYSA and earn $100?
The winner is clear in this particular scenario. Pay off the debt. But that’s not always the case. It’s not always this clear-cut. That’s because debt can take many forms, and so can investments. Let’s dive into it all a bit further…
Simple Interest vs. Compound Interest
To complicate things a little more, there are two different types of interest you might encounter.
The reason it’s important to know the difference is because over many years they can have a huge impact on how much you earn, or have to pay. Not to mention, banks and credit card companies always try to pull the wool over your eyes when lending money. They make interest rates and programs sound reasonable, but in reality, they are focused on maximizing their profits!
Simple interest is applied only to a principal balance. For example, traditional mortgages, car loans, and personal loans often charge you simple interest. You owe X, and interest is charged based on X.
Compound interest is not only when interest is applied to the initial principal, but interest is also applied to any previously accrued interest too! It’s exponential, meaning interest grows more interest. This can be great in the case of investments, but devastating when it comes to debts. The longer the time of a loan or investment, the bigger the impact!
Understanding Debt
At its worst, debt can wreak havoc on your finances. We all know people who are in buckets of credit card debt and end up digging themselves into a deeper hole every day.
But at its best, debt can act as a financial catalyst. A mortgage can help you purchase a home, or student loans can get you a college degree that triples your earning potential.
Before you decide that all debt is bad, it’s worth thinking about what type of debt we’re discussing. The more you understand the different types of loans and how they work for or against you, the better you can decide between the choice of paying off your debt or investing your money instead.
Good Debt vs. Bad Debt
In the personal finance community, we tend to break types of debt into two categories: “good debt” and “bad debt.”
Good debt is typically when you take out a loan to purchase things that appreciate. Like a mortgage on a house, or student loans for a college degree. Good debts typically carry lower interest rates, typically under 6%. Even better, fixed interest rates mean that they won’t increase, and the balance won’t spiral out of control over time.
The idea behind good debt is that your appreciating assets will be worth more in the future. The belief is that you can do better things with your money (like investing) than pay off the debt as quickly as possible, which can offset the cost of borrowing that money.
Bad debt is borrowing money used to buy things that depreciate. Like a car loan for a brand new set of wheels, or taking on credit card debt to buy a fancy TV and sound system. Bad debt comes with interest rates higher than 6% (usually MUCH higher! – As of this writing, the national average interest rate on a credit card is 24%!). Combined with compound interest, bad debt can cause a loan balance to balloon. And, since the items purchased with this debt will be worth less over time, it essentially acts like a double loss. Ouch!
Of course, there can be some gray areas in the good or bad debt debate. But for the most part, it’s usually fairly easy to recognize by the interest rate and what the loan was used for.
Sooo… going back to our original question: should you pay off debt or invest… What type of debt is it?
The downsides of too much debt…
In controlled amounts, good debt can help you build wealth. But that doesn’t mean the more you take on the better it is for your finances. Too much debt in any form (even the non-nefarious kind) can crumble like a house of cards. For example, just because a mortgage on a house is considered good debt, does that mean you should borrow 100% of the purchase price and buy a mansion that’s outside of your reach? Nope!
Having too high of a debt-to-income ratio can cause other money difficulties. It can tank your credit score, which can negatively affect other areas of your finances. Plus if your monthly debt commitments are too high, it can impact your ability to save and invest for retirement. Not to mention that high amounts of debt can negatively affect your mental health and cause financial stress.
So, there are certainly plenty of good reasons to use extra money to pay down debt vs. invest!
Understanding Investing
Investing is one of the pillars of personal finance and for good reason! Investing can help you to build wealth for the future, become more financially secure, and enjoy a comfortable retirement. In fact, we would argue that it’s pretty much impossible to do these things without investing. Here’s why…
Inflation is eating your money
Unless you live under a rock, you’ve probably heard politicians and common folks alike complain about inflation. Inflation, simply put, is the increase in the cost of goods and services over a given time. For example, if the cost of a movie ticket increases from $17.50 to $18 over the course of a year, you can say that the rate of inflation at the cinema is ~2.9%.
The issue with inflation is that when the prices of goods and services increase, our money isn’t able to stretch as far, and our buying power decreases. For example, if you have $100 in savings or cash, and the rate of inflation over the next year is 4%, your money will only have the buying power of $96.
While 2 or 3% may not sound like much, the effects can be catastrophic for your finances over time. For example, if inflation sits at 3%, the value of your money would be halved in just 23 years!
Investing gives us a way to hedge against inflation. Because it earns us returns at a rate that outpaces inflation. For example, the overall stock market has returned an average of around 10% over the past 30 years, allowing investors to beat inflation over that time, and then some!
Saving vs. investing
While under your mattress might feel like the safest place to sock away your money for retirement, this isn’t the case. You can’t save your way to retirement (unless you make an insane amount of money). You have to invest your dollars to grow a nest egg large enough to sustain you for the post-work years.
For example, if you were to save $600 every month in a checking account over 40 years, you would end up with $288,000. But, if you invested that money into the S&P 500, assuming an average return of 8%, you’d end up with around $1,932,647. That’s nearly 7 times more than what you would have if you had opted to save!
The reason why those numbers are so different is due to the compound returns that we talked about earlier. When you invest your money for long periods, the interest you accrue begins to earn interest. And over really long periods, compound interest starts to do more heavy lifting than your actual newly saved contributions!
Yes, there is some inherent “risk” involved in investing your money. But the biggest risk is not investing at all! By not investing, you’re taking a known risk, letting inflation eat away your money slowly, and you’ll have far less saved for retirement.
The best time to invest was at birth, and the second best time is right now. If you haven’t begun your investing journey, take a moment to read this beginner’s guide and our overview on how to buy index funds. Your future self will thank you for it!
Invest or Pay Off Debt?
Now that we’ve come to the conclusion that paying off debt and investing are both important and necessary, which should you tackle first with your extra cash?
If the easy answer hasn’t revealed itself by now, that’s OK! It’s not always so straightforward, and it highly depends on your personal circumstances. Here are a few things to consider when deciding whether to invest or pay off debt.
Whatever you decide, don’t ignore the other…
It’s worth noting that whichever decision you end up making, you can’t ignore the other area completely. Remember, investing and paying off debt are BOTH important to your finances and eventually both need to be tackled.
If you choose to prioritize investing, be sure to always make the minimum payments. Missing a single installment on a loan will delay your progress. Or worse, missing a couple of payments in a row might mean defaulting on a loan and getting into even bigger trouble. Never turn your back on minimum debt payments.
Likewise, if you choose to pay off debt, it’s important to still plan and save towards retirement. It’s important to dig yourself out of a debt hole and pay off high-interest loans. But the longer you wait to start investing for retirement, the more heavy lifting you have to do to catch up later in life.
Often the answer is to do a little of both. 🤷♂️
Sometimes the answer is… neither???
In some very specific cases, you should not prioritize investing or paying off debt, but instead focus on saving.
“But didn’t you just say that the inflation boogeyman is going to come and cut our dollar bills in half while we sleep or something?”
Okay, okay, you got me! Saving does play an important role in personal finance as well. Having some liquid cash on hand is important because it can help to safeguard you from financial emergencies, like job loss or medical emergencies.
If you do not have any emergency savings, you should work to save up a basic e-fund before paying off debt or investing. Without an emergency fund, you may be forced to take on more debt to cover an emergency. Or, you might have to dip into your investments (at a bad time) if an urgent and unexpected expense crops up.
Ideally, we want you to aim to have a fully funded emergency fund with 3-6 months of expenses saved up. But that can take a lot of time, and we don’t want you to miss out on months or years of investment returns while you work towards this goal. So, if you don’t have any savings on hand, start by saving up a basic emergency fund of $2,467. Economists have found that having this amount of money on hand can protect you from most common financial emergencies.
If you have a retirement account at work, once you have taken advantage of an employer match, and paid off all high-interest debt, you can work towards building up your emergency fund to cover between 3-6 months worth of expenses.
Do you have an employer match?
One of the most important factors in deciding if you should invest or pay off debt first is whether or not you have an employer match on your retirement contributions. 401k matching is a common benefit offered by many companies and employers. One that can equate to free money invested on your behalf. While some employers offer a 50% match, others will offer a dollar-for-dollar match up to a certain amount, or percentage of your salary.
If you’re deciding between whether to invest your money in an account with an employer match or paying off debt, it’s probably a good idea to take full advantage of that company match, whatever it is. You’re essentially getting a 50% to 100% guaranteed return on the money you put into your account. This is WAY higher than any interest on your debt, or what you could hope to earn on average in the stock market. Don’t leave that free money on the table!
One important caveat: Vesting periods. Some 401k programs have a sneaky clause in there that states you only get the match (or a portion of it) if you stay at the company for X amount of years. So if you only plan on working somewhere for a short time, the match isn’t as lucrative as you might think because it could be revoked if you leave before the vesting period is complete. If you have an employer match program, read all the fine print!
Look at the interest rate
We touched on this at the beginning, but here is where most people land when they’ve got spare money and have already taken advantage of the low-hanging fruit (emergency fund and matching opportunities). You should make the decision based on how good or bad your interest rate is on the debt(s) you currently owe.
Paying off “bad debt.”
If your debt has an interest rate of around 6% or higher (likely “bad debt”), you’ll probably want to focus on paying this off first. Why? Because you’ll be guaranteed to essentially get a 6+% return on your money. By paying off this debt, you’re saving yourself from having to pay that interest in the future.
If you’ve got high-interest credit card debt, the effects of this strategy can be even greater. For example, you’re unlikely to earn a 20% return on your investments. So it makes more sense to pay this down as opposed to investing.
If you decide to work towards paying off your high-interest debt, it may make sense to use the “debt avalanche” payoff plan. This focuses on paying off the debt with the highest interest rate first. You can read more about this simple payoff plan here!
Hold off on paying down “good debt”
If your debt has a fixed interest rate of 5% or lower, you may want to prioritize investing.
Why? Because you can earn more money over the long run by investing than you would save by paying off this debt. If the average stock market return is around 10%, and your student loan is at 5%, you would essentially earn 5% on your money by opting to invest it, and miss out on that 5% potential gain should you choose to pay off your debt instead of investing.
Another note regarding student loans specifically, is to never prioritize paying them early if you are working towards forgiveness! A loan with future forgiveness is a VERY low priority.
Peace of mind…
Some folks really get upset when they imagine their debt sticking around for decades, even if it has an extremely low interest rate. Debt comes with a ton of downsides. It can cause some serious money stress and take up mental energy, even if you manage it well.
If you are very debt-averse, you should work to pay off your debt early. We would recommend focusing on maxing out your tax-advantaged retirement accounts each year, like your 401k and Roth IRA. Once you start doing that, you can begin to work towards paying down your lower interest-rate debt.
Money problems aren’t always straight-up math problems. Always consider what makes you feel the best in the long run and helps you sleep at night too.
Real-Life Examples
Let’s take a look at some real-life scenarios, and assess whether the best move is to pay off debt, or invest.
Example 1: Prioritizing debt paydown
Rob just received a tax return of $4,000. Woohoo! 🥳
He’s currently carrying ~$3,000 of credit card debt at 20.5%, and has student loan debt at 5%. His employer offers a 50% match up to the first $1,800 contributed to his 401k. And, he’s already got his basic emergency fund set up. What should he do?
We would recommend that Rob take $1,800 from his tax refund and use it to get that full 401(k) employer match. He essentially gets a 100% return on his money, since his employer contributes an additional $1,800 to his retirement account. Then, since his credit card debt carries such a high rate of interest, Rob should take the remaining $2,000 and use it to pay down his credit card debt. His student loan should be a low-priority debt for the time being.
Example 2: Prioritizing investing
Julia has an extra $500 each month in her budget, and she is wondering whether she should use that money to pay down debt or invest it.
She already has a fully funded emergency fund and no high-interest debt. She has a student loan at 4.5% and a mortgage at 3%.
Since Julia already has a fully funded emergency fund, and no “bad debt,” Julia should stash that extra money into a tax-advantaged retirement account! Pay off your debt as agreed, eliminating it slowly, while building up wealth in those investment accounts.
The Bottom Line:
Looking at your interest rate can help you determine whether you should pay off debt or invest your spare money. If your debt qualifies as bad debt, pay it down as quickly as possible! If you’ve got low-interest debt with a fixed rate, investing is likely the best option.
No matter what you decide, it’s important to never completely ignore the other scenario. And take into account the other financial stepping stones, like building an emergency fund and taking advantage of employer matching opportunities. As a last resort, think about whatever makes you sleep better at night!
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