One of the oldest debates in the personal finance realm has to do with the tough choice between paying down debt and investing. The argument goes something like this:
Paying down debt is pretty emotionally draining (it’s hard to send your money to a creditor each month without feeling like you get anything tangible in return), and debt is very expensive. Considering those facts, it makes sense to have a laser-like focus on your debt payoff plan, because that makes you much more likely to follow through with it, since focused effort will give you more of a sense of accomplishment.
On the other hand, you cannot take advantage of the magic of compound interest if you do not have any money invested. Similarly, you can’t take advantage of employer-matching of 401(k) funds, or of the tax breaks available for investors. Saving for retirement is also a difficult habit to get into, and having all of your additional money ear-marked for debt payoff not only means you have nothing left to send to your investments, but also that you won’t have made a habit of putting money aside for the future.
So, if you are carrying a debt burden, how do you decide whether it or your investments get priority? Here are some questions to ask yourself to help you decide:
1. What would change in your debt payoff plan if you did both?
Many financial advisors recommend turning off the all-or-nothing mindset when it comes to the question of debt or investment. While you do need to take care of your debt, it’s not as though you can’t start your investing until that is done. So look at the numbers. How much longer will you be carrying debt and how much more will you be paying in interest if you funnel some of that money into your 401(k) or IRA? And what rate of return can you expect in that same amount of time from your investment? Finding a happy medium to balance your debt payoff with your investments is often the best strategy.
2. How high is the interest rate on your debt?
Another important factor to consider is just how expensive your debt is. If you have several high-interest or toxic debts, such as credit card debt, it can make sense to prioritize paying them off. With the extremely high rate you are paying, speeding up the payoff will save you money in the long run. You can roll over the payment you were making to your investment once you have cleared the debt.
If, on the other hand, your debts are the relatively cheap and tax-deductible—such as federal student loan debt and mortgages—then it makes more sense to reduce your debt payment and increase your investment contributions, as your money will go farther that way.
3. What’s your financial personality?
Some individuals simply cannot abide being in debt. For them, there is no sense of rest until the debt is completely paid off. If you are one of these individuals, it can feel better to work on debt payoff, even if your debt is inexpensive. Just be sure to make your decisions with the help of a trusted financial advisor, because what feels good—even if it’s debt payoff—is not necessarily the best strategy. However, if you can take care of your own need to pay off debt while you have a plan in place for your retirement savings, go for it.
The Bottom Line
One of the reasons why you so often see conflicting advice on the issue of whether debt or investments should be prioritized is because it’s not a simple black and white issue. The answer will change depending on your circumstances, your preferences, and your debt.
I used to make the minimum payments on my debt in order to invest but I actually don’t like the feeling, so no matter whether it makes financial sense or not, this year I am tackling more debt, just for the good feeling of it.
We are paying off my girlfriend’s student debt as fast as possible but the mortgage will be paid off as slow as possible. That said, we still save for retirement with AT LEAST enough money to get the 100% free employer match!
We are like Pauline although we could have invested the money we will use to pay off the mortgage it makes us sleep better knowing that we owe money to no one.We have always invested money each month but just not as much as we could have due to wanting to pay off the mortgage. Now we have until we retire about another 30 years to save more $$ that is if we want to work that long 😉
Debt first — or safety net first then debt!
For us, it’s a balancing act. We took on a decent amount of debt (~$88K beyond our mortgage on our home) in order to in real estate during the RE crash. While we’re focused on paying that down for now, we know that if the right investment came up we’d be okay borrowing again to take advantage of the opportunity. That said, all of this is after making hefty contributions to 401Ks and IRAs. Time is our friend there, and we’ll take as much of it in those accounts as we can get.
If I lived in the US there would be no way I would be paying off debt, interest rates are just too low and there are plenty of ways to be making around 3-4% PA with little risk.
As I live in Australia and the interest rates are near 5.5%, things are a bit different.
I would prefer to pay off all debt but the house before I would begin investing. I agree though, that personality does play a huge role in what people choose to do. My decision to pay off debt first came from a personal conviction that I did not want to be in debt to anyone. So that’s the route we chose and it has worked out great.
I think that is a great way to go. Being debt free (besides my mortgage) has always been important to me
We are trying to get rid of debt….I feel like I am just being too optimistic although I am investing in a few small nesteggs that are tax deferred. Thanks for the discussion! Oh by the way Mr. CBB sent me 🙂
Welcome. Hope I can help you in some way in 2013 🙂
It’s impossible to give a blanket answer to this question (although I always love when it’s asked). It always depends on several variables.
Outside of my mortgage, I have no other debt. But if I had other debt: car loan, etc. I wouldn’t be in a hurry to pay it off. The FED is devaluing the dollar like it’s their job. If dollar devaluation and inflation benefits anyone – it’s people in debt (like America).
Your point about paying off debt being emotionally draining is true, but compound interest also applies to your debt as well as your investment, because it’s extra interest you’re not paying in the future. It’s mainly why I’ve bought all presents with cash this year and pulled my belt in rather than use credit cards. Next month will be difficult, but at least those present won’t keep costing me.
The way I encourage myself, is by using a spreadsheet with all our balances and assets on it. That way, when I pay off debt, I see my net worth increase and so I do feel like I’m getting something back then.
I completely agree with your point.