Which is Better: Investing or Paying Off Your Debts?

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.

Recommended Articles

‘Healthy’ Foods That Might Be Harming Your Gut and What to Choose Instead

As our world produces and demands more processed foods for convenience, marketers are also getting clever. Foods are being labeled to cater to those with dietary requirements or those looking

5 Surprising Countries Where You Can Retire with Less Than $100,000

When retirement is inching closer, you might wonder about the kind of lifestyle you can lead and the level of financial security you will have if you just have about

fire method for early retirement

The Real Truth About the FIRE Method for Early Retirement

The FIRE method for early retirement has taken off in popularity in recent years. But are the risks well understood by its adopters? Retiring as early as possible then living

Feeling Bloated? 25 Natural Ways to Fix Constipation

We’ve all been there. Things are rumbling in your tummy, you feel big and uncomfortable, but you just can’t seem to poop. Constipation happens to the best of us, and

5 Ways to Ensure You Get the Lowest Possible Mortgage Rate

A 30-year fixed rate mortgage is the most widely chosen home loan option because of the high financial predictability it offers. Follow these tips if you want to obtain the

Robots Will Take 52 Million Americans Jobs. Here’s What Will Happen

A new research report compiled by the Brooking Institution reveals that innovative automation technologies are set to replace millions of American jobs. In fact, more than 52 million American jobs in

Online Loan Companies Are No Easy Fix for Desperate Borrowers

If there is one thing that most Americans need right now, its more money. Online loan companies know this — and it's dangerous for many of us. Since the financial

investing in a volatile market

Investing in a Volatile Market for Long-Term Gains

Investing in a volatile market gives everyone the jitters. Novices, in particular, tend to sell in a panic and then wait for the right time to re-enter the market. Selling

Legumes: Nutrient Dense and Delicious, but Watch for These Preventable Side Effects

Legumes: Good or bad for you? The answer is, a little of both. And at the end of the day, what really matters is how your unique body feels when

4 Keys to Successful Retirement Planning

Retirement planning gives you the freedom to live life to the fullest. You can afford to have all the necessary comforts and amenities of life, go on a vacation occasionally,

Do Seniors Need Life Insurance Coverage?

Do seniors need life insurance coverage? Your golden years should be about enjoying the memories of one’s lifetime. Yet the reality of life is that we struggle to pay our bills

Better Investment Than a Casino? Probably a Fitness Club

We all aspire to be healthier. Who doesn’t aspire to lose weight and exercise more as an annual New Year’s resolution? Yet well-intentioned aspirations and actions are not the same