Both paying off debt and investing for the future are essential elements of a healthy financial life. Yet, these two tasks seem to battle head-to-head when it comes to prioritizing their importance. Is it best to get out of debt as quickly as possible, or to simply pay the minimum amount on your loans and put any extra cash toward growing your savings? Here are some things to consider when determining the best decision for your funds.
Compare Your Earnings
One of the most common approaches to tackling the question of debt repayment versus investment is to compare the interest rate of your debt to the returns on your investments. In general, high-interest loans that exceed your investment earnings should be paid off first. Likewise, if you have low-interest debt, greater benefit might come from making the minimum payments and putting more money into your investment accounts. This seems like a simple solution, but for most people there is more to consider. For example, free money, such as an employer's match on a 401(k), must be factored into your calculations. Financial advisor Suze Orman suggests contributing enough to your 401(k) to get the maximum match. Also remember that when you pay off debt, there is a guaranteed return. With investing there is always an element of risk involved.
Consider the Type of Debt
All debt is not equal. The type of debt you have can play a role in the decision as to whether to pay it off as soon as possible or put your money towards investments. High-interest loans that are not tax deductible, such as credit cards and car loans, should be paid off as quickly as possible. Tax-deductible debt that is seen as more of an investment, however, such as student loans and home mortgages, can actually save you money. The IRS allows you to deduct the lesser of $2,500 or the amount you paid in interest on qualified student loans that were used for higher education expenses. The IRS also provides a home mortgage interest deduction. Most home mortgage interest is fully deductible.
Find a Balance
Many experts believe that the answer to whether to pay off debt or focus on investments is to simply do both at the same time. Delegate enough funds to pay off more than the minimum loan payment while concurrently setting aside cash in the investment vehicle of your choice. This approach ensures that you don't lose valuable time to stash cash for retirement while also making a dent in your costly, high-interest debt. There are a number of different budgeting methods that account for both debt repayment and investments. For instance, the 50/30/20 budget sets aside 20 percent of your income for savings and any debt payments above the minimum. Oprah's Debt Diet allots 15 percent of income to debt repayment and 10 percent of income to savings. Financial expert Dave Ramsey offers a back-and-forth approach to tackling debt and investments. He suggests saving $1,000 dollars in an emergency fund before working to get out of debt, excluding your home mortgage, as quickly as possible. Once all debt is eliminated he advises to go back to building an emergency fund that contains enough funds to cover at least three to six months of expenses. Next, his plan calls for investing 15 percent of all household income into Roth IRAs and pre-tax retirement plans while also saving for your child's college education, if applicable.
Determine Your Goals
Everyone's financial situation is unique so it only stands to reason that your personal financial intentions will play a part in your decision. For many people, being debt-free offers a sense of relief that can't be quantified. For others, having an emergency fund that'll cover eight months of expenses helps them to sleep at night. Emotions can sometimes overrule logic when it comes to financial decisions.
The Bottom Line
There is no cookie-cutter solution to the question of whether it is more important to pay off debt or invest. Take a look at your personal finances to determine where your money will make the most impact. If the hard math doesn't help you to decide between one or the other, try tackling both at the same time or put your focus on the financial goal that will give you the most peace of mind.
More From Investopedia
- student loans