Pay Off Debt or Invest?

pay off debt or investOn 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.

Final Thoughts

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.

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Comments

  1. says

    If you are investing in taxable accounts you need to take the tax hit when you sell into account too since it will reduce your overall return.

    Great post! I agree with your basic point, although we haven’t had too many opportunities to practice it as we only have 1 type of debt at the moment.
    Emily @ evolvingPF recently posted..Financial Wrongs from the PastMy Profile

  2. says

    I think it mostly comes down to the interest rate you are paying on the debt. If it’s credit card debt, you almost always benefit more by paying that off first. It gets trickier when the interest rate on your debt is less than 10%. Then you really need to analyze the current market conditions and how concerned you are about your debt. You might be more motivated to just keep working at paying off the debt to get some emotional relief.

  3. says

    I like your approach to the question. I think snother, difficult to quantify, factor should also often play a role in the pay off debt vs. invest choice. Debt = risk. When you’re in debt, a finite risk exists that things will go enough haywire in your life that you’re unable to repay that debt. Depending on your circumstances, savings, level of debt, etc., the risk may be minute, approaching zero. But for the millions of Americans who live paycheck to paycheck, depend on a single income, or have little savings, paying off debt at any interest rate could make more sense than investing, I think.
    Kurt recently posted..United Airlines Shakedown?My Profile

  4. says

    I say, yes.

    You should always be paying off debt and always be investing.

    If you have large, high rate, short term debt like credit card, pay the card and invest in yourself by putting money in a emergency fund because you obviously don’t have one. If you have long term debt like a mortgage, pay it off and invest by making extra payments on the mortgage and some cash into your retirement / passive income strategy.

    Budget, and allocate your limited funds appropriately. But always pay down debt and always invest.

    Yes. Yes. And yes.
    Jack @ Enwealthen recently posted..Get Paid For Your Opinion In A Focus GroupMy Profile

  5. says

    This is a question that we’ve really struggled with over the years. Our student loans are locked at 3%, so we just paid the minimums for years, choosing to invest instead. But now that we’ve decided to have me stay at home with our daughter, we have changed our mind about this and have now entered turbo debt pay down mode. At this point we don’t care about the interest rate, we just want the debt gone so we can stop worrying about it. Math-wise it might not be the right move, but the peace of mind it will bring us will be worth so much more than any amount of money!
    Dee @ Color Me Frugal recently posted..10 Side Hustles For Extra Cash in Your Pockets NowMy Profile

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