One question that comes up over and over again is whether it’s more important to prioritize investing or paying off debt. Obviously both are important, but when money is limited how do you decide between the two?
While there’s no one answer that’s right for everyone, here’s an order of operations that will help you make the best decision for your personal situation.
1. Pay the Minimums on All Debt
Given that your payment history is the biggest factor in determining your credit score, and that your credit score impacts so many areas of your financial life, making at least the minimum payments on all your debts on time is the first priority.
Doing so will help you build a positive credit history, and more importantly it will keep you from unnecessarily damaging your credit and making the rest of your life more difficult.
2. Create a Sustainable Plan
While the temptation is to dive right in and start putting your money to work, it’s usually a good idea to step back and make sure that you have good handle on your budget.
Now, the goal here isn’t to micromanage your finances or judge your spending habits. The goal is simply to put a system in place that allows you to make consistent progress without sliding back into debt.
There are plenty of tools that can help you with this. Mint and Personal Capital make it easy to track your spending, while You Need a Budget helps you put a more comprehensive and proactive plan in place.
You could also create your own spreadsheet, or simply set up automatic transfers to your savings accounts and loans and limit yourself to spending only what’s left.
However you do it, getting a handle on how much money is coming in, where it’s going, and how much you realistically have available to put towards either your investments or your debts will help you create a sustainable plan you can actually stick to.
3. Build a Small Emergency Fund
No matter how much debt you have and what the interest rates are, it’s a good idea to build a small emergency fund before you start making extra payments.
The reason comes back to sustainability. Unexpected expenses will come up whether you want them to or not, and having some cash on hand will allow you to handle them without interrupting your plan and without having to resort back to debt.
The exact right amount will depend on a number of factors, but a $1,000 emergency fund will usually be enough to handle most unexpected expenses.
4. Max out Your 401(k) Employer Match
If your employer offers a 401(k) match, it’s usually a good idea to max that out before putting extra money towards your debt.
It’s simply a matter of return on investment. Every extra dollar you put towards your debt earns a return equal to the interest rate on that debt. For example, $1 put towards a credit card with a 15% interest rate earns you a 15% return.
For the most part, your 401(k) match will represent a 50% to 100% return on investment, which is higher than just about any type of debt you could have. It’s simply a better return.
Of course, there are always exceptions. Your employer match may be subject to vesting, which could decrease its value. You may also receive a smaller match, in which case it’s possible that paying off certain debts would provide a better return.
But in most cases, maxing out your 401(k) match will provide a better return than making extra debt payments.
5. Pay off High-Interest Debt
At this point, the question of investing or paying off debt largely comes down to two variables:
- The expected return on investment
- The likelihood of getting that return
It’s reasonable to expect a balanced portfolio to produce long-term returns in the range of 6% to 7%, but that’s not guaranteed. It could be higher or it could be lower, and either way the journey will be full of ups and downs.
On the other hand, the return you get from paying off debt is absolutely certain. Putting extra money towards a loan with a 10% interest rate earns you exactly a 10% return.
That certainty makes it an easy win to pay off high-interest debt before contributing extra money towards your investment accounts. If you can get a guaranteed return that’s greater than or equal to the expected, but non-guaranteed, long-term return of your investment portfolio, it’s really a no-brainer.
6. Math vs. Emotion
This is where things start to get interesting. Because once you’ve handled the steps above, there’s no obvious next move.
On the one hand, prioritizing investing over paying off low-interest debt will likely lead to better returns. Research shows that a portfolio split evenly between US stocks and US bonds has never returned less than 2.4% over any 10-year period, which suggests that you are almost certainly better off investing over putting extra money towards debts with an interest rate of 2.4% or lower.
On the other hand, research also shows that carrying debt “exerts an enormous negative influence on happiness” and that paying it off can provide significant emotional relief. That is, in addition to saving you money, getting rid of your debt can might make you happier than having more money invested.
I would look at it this way:
- The lower the interest rate on you debt, the more I would lean towards maximizing your investments simply because doing so will likely make you more money.
- When your interest rates are middle-of-the-road – say 4% to 5% – consider striking a balance. Putting half your money toward investments and half toward debt will help you make progress in both directions.
- If having debt is stressing you out or making it hard to sleep at night, don’t be afraid to prioritize paying it off even if the numbers argue for investing. This may be one of those rare situations in which money truly can buy happiness.
7. Snowball Debt Payments into Your Investments
This is a key point that often gets overlooked.
If you really want to get the most out of all of this money you’re putting to work, you have to snowball your debt payments into your investments once the debt is paid off. That is, if you’re putting $200 a month towards your debt, once that debt is gone you need to start putting that $200 towards your investments.
The reason for this is that while paying off debt can provide a better, or at least comparable, return to investing, it only does so for the life of the loan. Investing, on the other hand, typically provides decades of compounding returns that you’ll miss out on if you stop contributing as soon as your debt is gone.
Of course, maximizing your long-term return shouldn’t be your only consideration. Or really even your first consideration. The primary goal of any good financial plan is simply to help you build a life that makes you happy, and that will often lead toward spending money on things that don’t provide any return.
But from a purely financial perspective, snowballing those debt payments into your investments is the best way to grow your net worth.
Find Your Balance
While the first few decisions here are pretty straightforward, the question of investing vs. paying off debt quickly becomes murky. Without a definitive answer, you might feel anxious about making the wrong choice and avoid doing anything at all.
If that’s how you’re feeling, it’s worth remembering that both are great choices and that any progress is good progress. If you use the steps above to chart out a reasonable path forward and focus on making consistent progress, you’ll come out ahead no matter what.
Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families.