The question of all questions in financial planning for individuals in their 20’s and 30’s. This is, by far, the #1 question I hear from those carrying credit card or student loan debt. It’s a great question and one that isn’t exactly black and white.
When the choice is paying down debt or investing, it comes down to a few different things. What is the interest rate on the debt? Would you be investing in a 401k that offers a match or somewhere else? What is your emotional attitude towards having debt? When does it make sense to invest over paying down debt, and is it the right emotional decision for you?
Let’s look at each of these in more detail, and hopefully, one of these scenarios applies to you and you’ll be able to make the right decision.
The higher the interest rate, the sooner the debt must be paid down. While there is no set in stone rule for what qualifies as high-interest debt, I recommend anything over 5% as a priority.
Any debt (non-mortgage) over 5% should most likely be a priority over investing it. There’s a good chance you could earn over 5% on that money if you invested it, but there’s no guarantee.
When you’re paying down debt greater than 5%, you are guaranteeing yourself the same return on that debt, because you’re no longer having to pay someone else that interest. Every amount you pay down is more money you get to keep in your pocket.
Anything under 5% interest and you’re okay investing that money as opposed to paying down the debt. As long as you are investing in a good index fund or a mix of high-quality funds, you should realistically be able to earn over 5% on that money.
Here is just about the only exception to the “paying down debt greater than 5% first” rule. If the option you’re weighing it against is your 401k and you receive a match on that 401k, then you must go with the 401k first.
Say the max match on your 401k is 3% if you put in 5%. If that’s the case, then your priority must be to contribute 5% to your 401k. This is guaranteeing a 60% return on your money right off the bat because of the match. As long as none of your debt is greater than 60% (I hope not), then you’re better off contributing to your 401k.
However, once you get to the max match your employer provides, your priority should revert to paying down debts of greater than 5% interest.
This is big for many people. Now that we know any debt greater than 5% should be a priority over investing, any debt below that might also be a personal priority, depending on your emotional attitude towards carrying debt.
I can make the case all day (with proof) that you’re better off investing your money as opposed to paying down low-interest debt. However, to many individuals, just having the burden of carrying debt far outweighs the opportunity of the return you could get from investing.
I get it. Carrying debt, no matter the interest rate is never a lot of fun. The emotional stability that being debt free provides can more than outweigh the return you could have gotten by investing. For your lower interest debt, it truly comes down to your personality.
As I mentioned, it makes sense to invest your money over paying down debt when you can get a return on your investment that’s greater than the interest on your debt. If that’s the case, then you’re better off investing and being your own bank. I can show you numbers all day why it’s the better option.
However, this is when emotions get involved. While I can prove to you it makes more sense to invest your money, your emotional state of being debt free may outweigh the investment return opportunities.
That’s okay. It truly is your decision to make. I will never sway my clients to do one thing over another but rather lay out the options and let them choose what makes them feel better when it comes to this issue.
So, what are you going to do? Pay down debt or invest? Good luck!
NextGen Wealth, LLC is a registered Investment Advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities product, service, or investment strategy. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor, tax professional, or attorney before implementing any strategy or recommendation discussed herein.
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