The debt vs. investing question has been around for a really long time. Some people believe that paying off your debts should be your first priority, while some others believe that building a profitable investment portfolio makes more sense financially, especially if you are young.
The truth is that there is no right answer to this question. The answer to this question entirely depends on your financial situation and the type of debt you have.
Good vs. bad debt
How much debt do you currently have? More importantly, is it good debt or bad debt?
Good debt is something that can increase your net worth in the long term. Perhaps the best example of good debt is a mortgage. It takes years to pay off a mortgage and you will probably pay tens of thousands of dollars in interest alone over the course of the loan.
However, with each payment you make, you build equity in your home, which can pay off for you in the long term.
Similarly, an education can be worth going into debt for, if it opens up a wide range of high-paying employment opportunities for you.
Moreover, you are allowed to deduct mortgage and student loan interest — up to a certain amount — from your taxable income. This is one of the important reasons why mortgage and student loan are considered good debt by many.
Now, let us turn our attention to bad debt.
Bad debt is something that drains away your hard earned money. It does not contribute to your overall net worth in any way.
The best example of bad debt is credit card debt. Currently, the average interest rate on credit cards is 21%, which is exorbitant to say the least.
What makes credit card debt more dangerous is the fact that a vast majority of people are happy to pay the minimum amount due every month, without thinking about the consequences.
Let’s assume you have $10,000 in credit card debt. If you pay 3% of your total outstanding balance every month at 15% APR, it will take you 185 months — roughly 15 years — to pay off your debt in full.
By that time, you would have paid $6,798 in interest alone.
Settling the debt vs. investing debate
Let us assume that you have built a diversified investment portfolio which consists of stocks, bonds, fixed income investments, and commodities.
With this type of portfolio, you can expect to get a return of 6% to 7% on a yearly basis. The rate of return, needless to say, is not guaranteed and can differ greatly based on the stocks you pick as well as a number of other external factors.
Let us now that you have a considerable amount of credit card debt, on which you are paying 15% interest on a regular basis.
In this scenario, you should pay off your credit card debt first, no question about it. By investing your money, you can only expect to get a 6% to 7% return. By paying off your credit card debt, on the other hand, you are assured of a 15% return.
Let us now consider a different scenario.
You have a mortgage, the interest paid on which is deductible. You also have a few other debts, the interest on which is 3% to 5%.
Your employer makes a generous offer: They will match up to 6% of your annual contributions towards your retirement account. In this case, saving for retirement should be your priority, since your debt is at a manageable level.
Debt vs. investing — what makes more sense?
The formula you need to use to arrive at a decision is quite simple. Let us assume that you pay x% interest on your debt on a yearly basis and you stand to get a y% return from your investments on a yearly basis.
If x is greater than y, you should pay off your debts first. If y is greater than x, you should focus on maximizing your investments.
There is, however, one important factor that needs to be considered when it comes to answering the debt vs. investing question.
Being in debt can be emotionally draining for most people. If you spend most of your monthly income on debt repayments and left with next to nothing to save you might feel insecure about your future, which in turn can affect your peace of mind.
In this scenario, paying off your debts can give you a sense of security, which can be invaluable.
Generally speaking, your debt-to-income ratio — the amount of money you spend on debt repayments out of your overall income — should not be more than three to 10.
In other words, you should not spend more than 30% of your paycheck on debt repayments.
Things to remember
- Before you decide to pay off your debts or invest your money, make sure you have an emergency fund, which you can access any time you want. It should be, at the very least, three times your monthly income.
- If you have credit card debt, pay it off first, irrespective of other factors. The only exception is if you use your credit card only for essential expenses and if you manage to pay it in full every month.
- If the interest on your student loan is more than 6%, you should try to pay it off as quickly as possible.
- If you only have a mortgage and a few other low-interest debts, you should primarily focus on building a solid investment portfolio.
- Make full use of employer contributions to your 401(k) account. It is free money which will continue to earn interest for years, a proposition you should not turn down for any reason.
As you can see, the answer to the debt vs. investing question is highly subjective. It depends on your current financial situation, the amount of debt you have, and the interest you pay on a yearly basis.
Consider all the factors discussed above and make a decision which makes more sense for you financially.