On any given day, you can visit a random personal finance blog and I bet you will find this very question: should I pay off debt or invest in the market? The standard answer that you will find 99% of the time is if your debt is costing you more than you can earn in the market, then yes you should pay off debt.
For example, let’s say you have a credit card that has an 18% interest rate. Given that 8% is a very conservative long-term return assumption for the stock market, you can see that paying off debt makes sense here. After all, why invest to earn $0.08 per dollar when you are paying $0.18 per dollar on your debt? You would be losing $0.10 per dollar if you followed this logic!
But when we move our attention to lower interest rate debt as well as debt that can be deducted on your taxes, the story becomes a bit more confusing.
Using A Simple Guide To Answer Your Question
Many times, you can use the guide below to figure out which makes the most sense given a situation:
- Interest on debt equals more than 8%, pay off debt
- Interest on debt equals less than 2%, invest
- Interest on debt is 3-7%, toss up
Using this guide, the answer to pay off debt or invest becomes much easier to answer. If your debt is costing you 8% or more, meaning the interest rate is 8% or higher, then the smart financial move is to pay off the debt.
When your debt is costing you 2% or less (again, interest rate is 2% or less), then the smart financial move is to invest your money and take your time paying off the debt.
The gray area is when you have debt costing you between 3-7% interest. In this situation, the best financial move is to simply act. You can pay off debt or invest in this situation because the interest you earn from investing and the interest you save by paying debt is roughly the same. So at the end of the day, either choice makes sense here.
A Wrinkle In The Equation
While it is easy to look at the guide above and make a decision based on that, there is a wrinkle to the guide. While on paper the guide is great, it is not real life. You see, the average investor never actually earns what the market earns. The market may historically earn 8% per year, so that is the number used above to justify what to do. But the average investor earns roughly 2% per year. That is nowhere near the 8% historical return.
Why is this? Because most investors give in to short-term volatility. They listen to the noise that the media feeds them and are constantly buying and selling. This is the absolute wrong thing to do.
You should stay invested in the market for the long-term, during both the ups and downs. I can’t tell you where the market is going to go tomorrow. Neither can you nor the “expert” on TV. It’s a guess. They will give you all sorts of facts to back up their conclusion, but at the end of the day, they have a 50/50 shot at being right, just like you, me or a monkey throwing darts.
I can tell you that over the long-term, the stock market will rise. Yes there are bumps along the way, but that is to be expected. I can pick out random one or two year periods where the market dropped and was negative, but looking at the trend of the market over the long-term, it is positive.
Yet One More Issue
Unfortunately, there is still one more wrinkle to the guide. This issue is your intentions. You see, you might see the guide and decide that investing is the best option for you. You might also read the part above about investing for the long-term and feel you can handle that too.
But then we come to actually investing the money. Many times we plan on investing the money, but then something catches our eye and we buy it. Or we want to take an awesome vacation. Or we want to buy a bigger house. In the end, while we planned on investing, we never actually got around to it. I see this all of the time. So taking everything into account, what should you do, pay off debt or invest?
The Real Answer To Paying Off Debt or Investing
The answer at the end of the day is to first take into account the guide from above. See what it tells you to do. Then think about yourself, your goals and your situation. Does the thought of having credit card debt keep you up at night? Maybe you are worried about not having enough money saved for retirement?
You have to take into account human emotions. How you feel will be the final answer as to what you should do. If you have credit card debt at 8% and decide to invest your money instead, are you making a mistake? Financially speaking, yes you are. But finance is personal. If investing the money instead helps you to sleep at night, then it makes sense to invest.
Conversely, if paying off your credit card debt that carries a 2% interest rate takes the worry out of your life, then you should absolutely do that. Again, you might be wrong financially, but personally you are right.
This is because we all have different dreams and goals for our lives. What makes sense for me might not make sense for you. So don’t get caught up trying to figure out what makes the most sense financially and not take into account your personal feelings.
You have to listen to your feelings, otherwise you will be miserable with the decision you made. And when you are unhappy about something, you tend to avoid doing it. So even though you intend to pay off the debt or you intend to invest the money, you will never actually get around to doing so.
A Few Tips When It Comes To Investing
Lastly, if you do end up choosing to invest, as I said before, you need to make certain you actually invest your money and not spend it instead. To avoid spending the money, make sure you set up a transfer each month to automatically move the money to your investment account. You need to do this because automating works.
As for staying invested for the long-term, you need to stop your emotions from interfering. This is easier said than done. But, if you have a plan, you will be successful in the stock market.
While it makes perfect sense to figure out what is the smartest move to make – to pay off debt or invest, you cannot just base the decision solely on math. You have to take your emotions into account and weigh these as well. After all, there is no point in saving for the future if having credit card debt hanging over your head is stressing you out and ruining your health.
Figure out what makes the most sense financially and then listen to your gut and act. As long as you act, you will be fine in the long run. Regardless of the interest rate, paying off your debt is a great financial move long-term as is investing for your future. Both will help you to increase your net worth and put you on solid financial ground.