Eliminating debt means you can stop burning money each month in the form of interest payments and find better uses for that cash. And starting to invest as early as possible is one of the best ways to put your money to work for you, giving it more time to grow and benefit from compounding (or when our investment returns generate returns of their own and so on).
But you might be wondering about the order of operations: Should you pay off debt before investing, or should you funnel as much money as possible into investment accounts while paying the minimum monthly debt payments? Or is there a happy medium?
If you suspected the real answer is “it depends,” you’d be right. Here’s how what type of debt you have affects whether you should prioritize paying it off or start investing.
Credit card debt is generally the most expensive form of debt—making it a huge barrier to building wealth. Interest rates vary significantly based on factors like your credit score and lender, but the average for new credit sits at a record high of 17.41 percent as of January 2019.
What’s more, minimum payments are often designed to be low so it takes a long time to pay off the debt, maximizing what we pay in interest. That’s why it’s wise to budget for non-essentials and build an emergency fund to avoid being tempted (or forced) to add to a revolving credit card balance.
If you’re weighing the decision to wipe out debt or invest, a smart move is to focus on paying off your credit card debt because you’ll likely save much more in interest than you can reasonably expect from investing gains. (Over the long term, stocks have returned about 10 percent annually, but that’s an average that includes significantly higher and lower figures some years.)
One exception: If your company matches a portion of your retirement contributions, it’s wise to invest at least enough to capture the match they’re offering. That’s basically free money.
For most of us, owning a home would be nearly impossible if we had to pay for it upfront. That’s what makes mortgage loans a powerful tool: They allow us to buy a home and live there now, while paying for it over the course of 15 or 30 years.
Of course, that advantage isn’t free. As of January 2019, the average interest rate on a new 30-year fixed mortgage in the U.S. was 4.82 percent. If you took out a mortgage for $100,000 under those terms, you’d pay just under $90,000 in interest over the life of that loan. So paying off your mortgage ahead of schedule could save you a lot.
But what’s a better use of money: using extra money to pay off your mortgage or investing it? Take this example: If you applied an extra $100 to paying down the above mortgage, you could reduce your total interest payments by nearly $30,000. But invest that $100 per month and earn 7 percent annual returns, and you could have nearly $122,000 after 30 years. (Remember, compounding returns are your friend.)
If you want to save as much money as possible—and you do, right?—you’d generally be better off investing extra money while making minimum mortgage payments.
Just as mortgages help many of us afford homes that would otherwise be out of reach, student loans help millions pay for a college education. Starting a career more than $37,000 in the hole (as the average 2016 grad with loans did) can be stressful. But is that good enough reason to prioritize paying back student loans over investing?
As of July 2018, new federal student loans for undergraduates carry an interest rate of 5.05 percent. If you graduated from college with $37,000 of student debt at that rate, you’d pay about $10,000 in interest over the life of a 10-year loan. Add $100 to your minimum monthly payment, and you’d save about $2,500. However, if you invested $100 each month instead, and earned 7 percent on average, you’d have more than $17,000 after 10 years.
As with mortgage debt, if you’ve got federal student loans, your best bet is likely to pay the minimum each month and invest any extra money. If, on the other hand, you have private student loans, which typically have significantly higher interest rates (such as 12 percent or more), it may make more sense to pay those down first—or refinance the loans at a lower rate.
How exactly you decide whether to pay down debt or invest extra money should be based on your unique financial situation. But these guidelines are typically a good place to start:
- If you have access to an employer-sponsored retirement plan (like a 401(k) or similar account), contribute enough to earn the full match, if offered.
- Then shift to paying off high-interest debt like credit cards or private student loans.
- Once you’re free of high-interest debt, use extra funds to build up your investment portfolio (again maximizing retirement accounts where possible). At the same time, pay at least the minimum monthly payment toward low-interest debts like a mortgage or federal student loans.