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

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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? The important thing to keep in mind when trying to decide between paying off debt vs. investing, is that if you’re in debt, you’re not alone. In fact, consumer debt reached $14.56 trillion at the end of 2020. 

Still you might be wondering, 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. Deciding whether it’s the right time for you to start focusing on investing instead of paying off debt—or at the same time—is a personal decision that takes careful consideration. 

“Should I invest or pay off debt?” is a question a lot of people struggle to answer. Fortunately, we’ve created this guide to help you through the processes so you can choose your next step with confidence. Keep reading to get a complete overview of everything you should consider, or use the links below to find the section that best answers your most pressing questions.

Evaluate Your Current Financial Situation

The first step to determining whether it’s better to pay off debt or invest is evaluating your current financial situation and deciding where to go from there. 

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. It’s also important to consider what type of debt you’re in, check your credit score, and look at other assets you may have. 

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.

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.

To help you get some more clarity, here’s what you should take a look at in terms of your financial situation so you can decide if you’re ready to start investing.

Compare Debt to Income

Your debt-to-income ratio is one of the biggest things to consider when you’re deciding between paying off debt vs. investing. At the very least, you should have a debt-to-income ratio that allows you to keep yourself in a fairly stable financial position and your credit score in good standing. If there’s a chance investing will affect your ability to make on-time payments, it’s better to wait to invest until you’ve paid off all your debt. That’s especially true if you’ve found yourself on unstable financial ground in recent months, which is nothing to be ashamed of. According to a recent poll, 23% of U.S. adults with credit card debt have added to it during the pandemic—so you’re not alone in these uncertain economic times. 

If you plan on getting a loan in the near future, you might also want to hold off on investing. Lenders prefer to loan money with a lower debt-to-income ratio. The quicker you pay off your debt and get below that threshold, the quicker you can qualify for the mortgage or car loan you’ve been wanting.

But how do you know what your debt-to-income ratio is? You’ll need to compare your income against what you currently owe. To do this, you should:

  1. Calculate your current income, whether that’s from one or several jobs.
  2. Make a list of everything you own—think checking account balances, savings account balances, retirement funds, and assets with significant value like your home, car, and any collectibles and their current value.
  3. Next, make another list of everything you owe—student loans, credit card balances, car loans, etc.

Once you take stock of your assets and income compared to everything you owe, you’ll have an estimate of your debt-to-income ratio and your financial standing, which can help you choose your next steps more effectively.

Do You Have Emergency Savings?

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. The last thing you want is to put yourself in a difficult financial position because you chose to invest your money. You never know what’s going to happen in life, so having some kind of emergency savings fund is an important part of staying prepared. If your car suddenly breaks down or you need to have your roof replaced, it’s important to have savings set aside that you can rely on.

If you’re having trouble deciding if you should pay off debt or invest and you don’t have an emergency savings account, try to increase your savings first. You don’t need to save tens of thousands of dollars, but having a little money set aside provides protection in case your investments don’t go as planned.

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.

Check Your Credit Score 

If you’re thinking about investing your money, check your credit score first. While investing typically has no effect on your credit score, you need a good credit score to get loans to buy homes, cars, and more—which means, making sure it’s in good standing should be a priority. 

If you have a lot of debt that’s dragging down your credit score, it could prevent you from reaching those goals. Not only that, but having a high amount of debt sitting around also means that it’ll continue to grow thanks to interest. And if you have a high interest rate, that problem only becomes so much worse. The longer you avoid paying off debt, the more you’re going to pay in interest and the harder it will be to pay off that debt.

So, if you have a lot of debt that’s accumulating high interest and hurting your credit score, the decision to pay off debt or invest is fairly simple—you should probably make debt reduction your focus for now. However, if you’re good on that front, now might be a good time to take on investing.

Compare the Different Types of Debt You Have

Looking at how much debt you have and your debt-to-income ratio is only part of the process. You also need to consider the types of debt you have. Not all debt is created equal. Some debt is hard to pay off quickly but comes with a low interest rate, while credit card debt is typically smaller with a higher interest rate. Take a look at the debt you have and separate it into different categories.

Once you understand the dynamics of your debt, you can make a plan to pay it down. Focus on paying off high-interest debt at first, or any debt that may lead to garnished wages. Once you’ve paid off your credit cards and any other short-term debt, you can focus on things like car payments and mortgages.

When You Should Focus on Paying Off Debt First 

So, do you pay down debt or invest first? There are lots of reasons you might want to pay off debt before you invest, but the rate of return is especially important. When you have debt, you pay interest on that debt every month. With credit cards (especially credit cards with high interest rates,) you could be paying hundreds of dollars in interest each month. That’s a return you simply can’t get from investing, which is why it’s often better to pay off debt before you invest.

Your credit score is another important reason to pay down debt before you invest. Credit scores are used to get important loans, such as home loans and mortgages. Your credit score is also used by landlords, insurance companies and more.

Because credit scores are affected by your debt-to-income ratio, you want to pay off any debt as soon as possible to keep your credit score solid. Once you’ve paid off your debt, you can start looking at investing apps. 

How to Boost Investments While Paying Off Debt 

Sometimes you don’t have to choose whether to pay off debt or invest, you might be able to do both.

Even if you’re focusing on paying off debt, there are still ways to invest your money without affecting your ability to pay off debt. For example, opening a savings account is a good way to stash some money away without making any risky investments.

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.

By contributing the maximum amount that your employer is willing to match, you can get the most out of your 401(k) while still paying off a little debt each month. The sooner you start contributing to your 401(k), the more money you’ll have when you retire.

When You Should Focus on Investing 

While paying off debt is typically the first step to getting started with investing, there are other factors to consider. Getting rid of credit card debt is important, but there’s no way you’re going to pay off a 30-year mortgage before you start investing. As a matter of fact, waiting too long to invest is actually counterintuitive.

If you have mostly long-term debt that carries a low interest rate, consider investing a little bit of your income each month. The more you can afford to invest, the more you stand to make. Just make sure you can still make your monthly mortgage payment, car payment, and whatever else you have to pay on a monthly basis.

Why Investing Sooner Rather Than Later Is Important

Investing can seem like a complex process, which is why a lot of people simply avoid it. The trick is, you need to get started as soon as possible to maximize your investment. The more time your investments have to appreciate or collect interest, the larger your investment portfolio becomes. 

If you want to save for retirement, you should be contributing to your employer-matched 401(k) and potentially opening an IRA or Roth IRA. As you make weekly or monthly contributions to these accounts, they’ll continue to grow at a faster pace until you can eventually withdraw your money at retirement age.

Paying Off Debts and Investing at the Same Time

One simple way to decide whether to pay off debt or invest is to do both at the same time. Just because you’ve got debt to pay off doesn’t mean you can’t invest a small portion of your monthly income. 

Keep paying the minimum payment on your loans and credit cards, but also make sure to take some of your discretionary income and put it toward investment opportunities, whether that’s your 401(k), stocks, or something else. Just make sure to choose low-risk investments so you don’t lose all that money.

What’s really important if you want to invest and pay off debt at the same time is having a budget. You can use the 50/30/20 budgeting rule to figure out how much money should go toward paying off debt and how much you can invest. Even small investments of $10 or $20 can add up over time, so it’s important to get started even if you start small.

Set Yourself Up for a Successful Financial Future

It’s no secret that investing is one of the best ways to make your money work for you and set yourself up for long-term financial stability. If you want to start preparing for the future, the best thing you can do is begin investing now. Whether you contribute to an employer-sponsored 401(k), start an IRA, or invest in bonds, you’ll be thankful you took advantage of these opportunities sooner rather than later. 



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