Should You Pay Off Debt Before Investing?

If you’re struggling with deciding whether to pay off debt first or save or invest your money, you’re not alone. What comes first — paying off credit card debt or building an emergency fund? It may take many years to pay off your student loans. Can you afford to wait that long to start saving for retirement?

Keep in mind that when you’re deciding whether to pay off debt or invest, it’s not always an either/or choice. It’s often best to invest and pay off debt at the same time, but it’s not always possible. When you must choose, you have to weigh the costs and benefits of both sides.

So, what should you do? Unfortunately, there’s no easy, one-size-fits-all answer. There are a variety of factors that you should take into account when deciding your course of action. Here are a few to consider.

Paying Off Debt: What to Prioritize

Is it better to pay off debt or save money? There are a lot of good things to say about paying off debt. It reduces stress, involves less risk, frees up credit you may need in an emergency and puts you in a better position for an economic downturn. 

If you’re thinking about paying off debt, take a close look at your interest rates. According to Lending Tree, credit card interest rates have reached an average of 24.61%. So, it’s often a smart idea to pay down any high-interest credit card debt you have.

Student loan debt can have an interest rate as high as 13.99%. Car loans may be as high as 24.99% depending on your credit score. While mortgage rates are usually lower than other forms of debt, they’re averaging 7.30% for 30-year loans and 6.81% for 15-year loans.

It’s generally smart to pay off your highest interest debt first, while you pay the minimum on your lowest interest debt. As you pay off a debt, you can add the amount you were paying to the account with the next highest interest rate and keep doing that until you’re debt-free.

Debt with fixed payments and interest rates, such as mortgages, car loans and student debt, is better to carry over because you can budget for it.

Keep in mind that you can get an income tax deduction for certain types of debt. You may be able to deduct the interest you pay for your mortgage and your student loans. If you have an interest rate lower than 6% on your mortgage or student loans, it may be better to keep them and save or invest the amount you would have paid over the minimum.

For example, if your tax rate is 25%, you are effectively paying 4.5% on a 6% interest rate that you deduct. So, if you can earn more than 4.5% on your savings or investment, that might be a better strategy. 

If you don’t qualify for a tax deduction on the interest you pay, you should probably prioritize paying your debts.

Investing Extra Cash: What to Prioritize 

Investing allows you to put your money to work. As it accumulates over the years, your investments grow with the help of compounding interest and they can provide you with passive income and a comfortable retirement. 

Should you pay off debt or save for retirement? Generally, it’s a good idea to contribute at least enough to your 401(k) to get your company’s match, since that is essentially free money. 

If you’re married and combining your finances, your spouse should contribute enough to get their company’s match as well. And remember that 401(k) and most traditional IRA contributions reduce your taxable income.

After you’ve reached the company match, you’ll need to take a close look at your interest rates, investment opportunities and overall situation. You may want to contribute to a Roth IRA or put away money in a Health Savings Account (HSA) if most of your debt is at lower interest rates. But it may make more sense to pay down high-interest debt once you’ve invested enough to get your company’s match.

Also consider the rate of return you expect to earn from your investments. High-yield savings accounts and money market accounts are currently returning 4 to 5.30% or more, and a diversified investment portfolio could provide returns around 5 to 8%. 

Review Your Personal Finances

Before you pay down debt or invest your extra cash, you’ll want to have a strong financial foundation and budget. Financial advisors typically recommend having three to six months’ worth of expenses saved up. 

At minimum, you should start with an emergency fund of at least $1,000 to $2,000. This is money that is not needed for your regular expenses and that you don’t touch month-to-month. It’s there for unplanned expenses like unexpected medical bills or home repairs.

You should also be able to make the minimum payment on all of your debts before you consider investing. This way, you’ll keep late fees from stacking up and your accounts will stay current. 

If you have other goals you’re saving for, such as a down payment or a wedding, you’ll want to consider how those fit into your overall financial plan.

Account for Emotional Investing

For some people, the feeling of being free of debt outweighs any investment returns. If that’s the case for you, or if you’re more risk-averse, don’t feel obligated to chase high returns and carry debt. Your peace of mind matters, too.

Even if an expected rate of return on an investment is much higher than the interest rate you’re paying on debt, there are no guarantees that the rate will continue. On the other hand, the money you save by paying off debt and avoiding extra interest is guaranteed.

If you’re more comfortable with risk and want to increase the likelihood you have the funds to retire comfortably when you want to, take advantage of the compounding interest that comes from investing earlier.

And remember, whatever you choose, you can always change your mind and switch up the way you’re paying down debt or investing as your income, expenses and financial situation change.

Review Your Options With an Expert

If you’re asking yourself, “Should I save money or pay off debt?” Talk to a Farm Bureau financial advisor. They can review your finances, answer your questions about paying off debt and investing and ensure that you’re making the right money moves to achieve your goals. Reach out for a consultation today.