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As you work to change your financial situation for the better, you may run into a tricky dilemma. If you find yourself asking, should I focus on investing or paying off debt, you aren’t alone.
The decision to prioritize debt repayment or investing will come down to your unique financial situation. You’ll need to choose the right path for yourself. But luckily, there is plenty of information to support either course of action.
Let’s take a closer look so that you can decide which option is right for you.
Investing or paying off debt: Which should I prioritize?
The decision to focus on debt repayment or investing can have a dramatic impact on your financial future. If you don’t eliminate debt from your life, then you could be stuck paying too much interest on your outstanding loans. If you don’t build your investments, then it may be difficult to take full advantage of the power of compounding interest.
Here’s a closer look at the merits of investing or paying off debt.
The case for paying off debt
If you have debts on your personal balance sheet, it can feel like a crushing financial burden. With unavoidable monthly payments constantly looming on the horizon, it can be easy to feel trapped by the debt.
That’s why many people choose to pay off their debts as quickly as possible. If you are lucky enough to have the funds you need to make progress on your outstanding debts, then you have the opportunity to eliminate a dark cloud that is constantly hanging over your finances.
Beyond the emotional component, high interest debt can be a major obstacle for a sunny financial future. If you have any high interest debt, then it’s likely that you won’t find an investment that can outpace the interest charges with investment returns.
For example, let’s say you have credit card debt with an interest rate of 20% attached. It is unlikely that you’ll find an investment that will allow you to earn more than a 20% return on your investment. With that, it’s probably a good idea to prioritize debt repayment over investing for the time being if you have any high interest debt in your life.
The case for investing first
Investing is a key part of building a bright financial future. The goal of investing is to put your money to work for you. At some point, you may strive to live off of the returns generated by your investments.
It can take some time to reach that point. And that’s why it is a smart choice to begin investing as soon as possible. But if you have debts on your books, you may think twice about prioritizing investing. After all, the tangible feeling of accomplishment that occurs when you eliminate a debt today may feel more enticing than the possibility of enjoying an investment return at some undefined point in the future.
In general, it is a good idea to prioritize investing if you have low-interest debts. With low-interest debt, you may be able to earn more in the long term by choosing to prioritize your investments.
For example, let’s say you have a mortgage with a 3% interest rate. Instead of focusing your extra cash flow on repaying that low-interest debt, your funds could be used more efficiently if you invested in an index fund with returns of 7% each year.
Although it will take longer to repay your debts, it could allow you to build a larger nest egg for retirement.
Should you be investing or paying off debt? Here’s how to decide
It’s decision time! Here’s how to decide if you should focus on investing or paying off debt.
Run the numbers
To find the most efficient way to use your funds, you will need to run the numbers on whether or not you should focus on investing. Although you can run these calculations by hand, there is a simpler option. Luckily, you can use this free online calculator to explore your options.
You’ll be able to enter the details of your debt. Plus, the amount you have on hand to save each month. As far as the expected rate of return goes, you should choose a reasonable figure that is based on your investments of choice.
For example, stocks have returned an average of 10% per year. Of course, past performance is not a reliable indicator of future success. But you can at least provide a ballpark figure to base your calculations on.
Once you run the numbers, you’ll likely find that it makes more sense to prioritize investing if you have low-interest debt. But if you have high-interest debt, then it makes more sense to prioritize debt repayment.
Don’t discount your gut feeling
The numbers of the decisions don’t tell the whole story. Many are happily able to follow a decision entirely based on numbers. However, the emotional component of our individual relationship should come into the picture.
Personally, I’ve struggled with the decision to prioritize investing or pay down my mortgage. My heart wants to throw money at my mortgage to eliminate such a large financial responsibility from my life. But with a low interest rate locked on my mortgage, the numbers point me in the direction of prioritizing investing for my future.
After debating the point with myself for months, I decided to strike a balance between the two. I have chosen to prioritize investing. But I still choose to pay off a small chunk of my mortgage every year.
I was able to reconcile myself to this choice after reading The Psychology of Money by Morgan Housel. In the book, Housel makes the point that you should approach money decisions based on what feels reasonable because it can be more difficult to follow through on a decision you aren’t completely sold on. If you find your heart and head stuck in a debate, then I highly recommend reading this book to clarify your choices.
Do you have to choose just one?
The good news is that you don’t have to choose just one or the other. Although this option will vary based on your budget’s constraints, you can choose to invest while paying down your debt at a slightly accelerated rate.
For example, let’s say you have $500 each month to dedicate to extra debt repayment or investments. You can decide to put $250 of the funds towards each goal. Or you may decide to put $400 towards investments and $100 towards your debts.
The best part is that you get to decide. If you can’t choose between these two great options, it never hurts to work towards your long-term financial goals from both sides. Take the time to strike a balance that aligns with your financial goals.
Whether you choose to focus on investing or paying off debt, you are making a smart financial decision. In either case, you will propel your finances towards the future you desire.
With that, you should continue with the choice that feels reasonable for your situation.
Which will you choose? Let us know in the comments!