How to Decide if You Should Pay Off Your Debt Or Invest

Debt

If there’s one thing you’ve heard over and over again about investing, it’s probably the importance of starting early. The more you invest now, the better off you’ll be later on. Right?

But what about the debt you still need to pay off?

Is investing for retirement and your future goals really a priority when you still have student loans, credit cards, a car loan and medical bills you need to pay off? The answer? It depends.

On what? Consider this…

Where Are You Starting From?

If you don’t know where you stand financially, it’s hard to choose your next steps effectively. So start by taking a financial inventory.

That is, make a list of everything you own financially speaking – think checking account balances, savings account balances, retirement account balances and assets with significant value like your home, car and any collectibles and their current value.

Then make another list of everything you owe – student loans, credit card balances, car loans etc.

Once you take stock of everything you own and everything you owe, you’ll have a clear picture of where you’re starting from financially, which can help you choose your next steps more effectively.

Do You Have a Cash Cushion?

When you’re just starting out, your financial inventory may not consist of much. But before deciding whether you should aggressively pay down your debt or invest, be sure to build up a small cash cushion.

While experts recommend an emergency savings fund stocked with 3-6 months worth of expenses, consider saving up at least one month’s worth of expenses before splitting your efforts between saving, debt pay off and investing. Having this initial cash cushion in place can help you avoid accumulating additional debt should an unexpected emergency expense arise.

Get Your Employer 401(k) Match

As you start to consider investing, find out whether you have access to an employer-sponsored retirement account like a 401(k), and whether your company matches any portion of your contributions.

Matching contributions from your employer are essentially free money, so consider funding any employer-sponsored retirement account up to the full match.

Assess Your Debt

While it’s important to always make the minimum payments on your debt to avoid late fees, default, and damage to your credit, deciding whether it makes sense to pay down your debt more aggressively depends on the details of your debt. That is the type of debt you have, the interest rates of each, and your respective balances.

Once you have this information in front of you, you can start to make some decisions. Is the return on your investments likely to be greater than or less than the interest you’re paying on your debt? If you’re looking at debt with a double-digit interest rate, like credit card debt, prioritizing your debt pay off may be your best bet.

Over the long term, balanced investment portfolios have returned roughly 7- 8% after inflation.

While past investment returns are no guarantee of future returns, this historical benchmark does show that extra payments towards debts with interest rates above 7 percent are likely to offer a better return than what you’d expect to get from traditional investments.

If you have any debts with an interest rate significantly below 7 percent, you might consider sticking with making minimum payments while starting to invest more aggressively in a well-balanced portfolio.

While getting into the habit of investing as soon as possible can be a good idea, it’s ultimately up to you to decide your financial priorities. If being debt free will offer you greater peace of mind, it might feel better to prioritize your debt pay off.

After all, there are no guarantees in the stock market, and there’s always the risk of your investments underperforming. Whereas paying off debt has a guaranteed, immediate return.

While there’s no one size fits all solution, taking financial inventory and considering your options before settling on any action plan will help you take your next steps more effectively.

If you need additional support, or you come into a complex financial situation, consider seeking more hands-on help. You can search for a professional financial advisor at napfa.org.

The one thing that holds true across the board, whether it’s paying off debt or investing, is that the sooner you get started, the better off you’re likely to be.

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