Should You Invest or Pay Down Debt?

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.

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.

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Tagged as: debt management, investing