This has been a debate within the financial community for a long time – should you start investing or pay off debt first?
Many people find themselves with some cash in their pockets, but they just don’t know whether to pay down a large pile of that pesky debt or start accumulating wealth through investing. The short answer is, both are important.
Investing is used to build your reserves and create passive income. It provides your family protection and security. Ultimately, investing is used to accumulate wealth for future retirement.
Paying off debt means lowering your risk and reducing stress. It will allow you to weather personal emergencies and economic recession/depression. Most importantly, you will have increased flexibility in your life, maximizing your personal happiness.
Both options sound pretty good, don’t they? Technically speaking, we need to look at two variables when deciding on whether to invest or pay off your debts:
- The interest you are paying on your debts after taxes
- The return you are earning investments after taxes
This simply means, if you are earning a higher rate of return on your investments than the interest you are paying on your debts, you should invest. If not, then you should be paying down all your debts to use your money the most efficiently. A prime example from this technical standpoint is only paying the minimum mortgage amount on your home that has a 3.5% interest rate and investing any remaining money you have at an 8% return. The difference is a positive 4.5%.
As I said, this is the technical way you should approach investing vs. paying off debts. However, once you factor in risk tolerance, this method goes out the window and becomes more personalized.
Here are what many financial planners are recommending these days, starting with the most important:
- If you have a retirement account through your employer, such as a 401(k) or 403(b), where they match up to a certain percentage, take the match. By doing this, you are instantly getting a 50% to 150% return on your money depending on your employer match.
- Build an emergency fund if you don’t already have one. This protects you against emergencies and if you don’t have one, you will most likely put an emergency on credit, digging yourself further into debt. Have at least three months of expenses set aside in a checking or savings account.
- Write down your debts and the interest you are paying on each one. Pay off the high-interest debts first and then continue to work your way down the list. This is called the debt avalanche and you can learn more about it here. Whatever you do, don’t stop paying off your debts. Find a way to at least pay the minimum every month, until you can contribute more.
- Open a Roth IRA and start funding it. A Roth IRA is an awesome retirement tool that isn’t taxed upon distribution and compliments well with an employer retirement account. Invest what you can each month and, if possible, try to fully fund it every year. Check the contribution limits as they change from time to time.
- Put money into a Health Savings Account (HSA). This is a special type of savings account that can only be used for qualified healthcare expenses. There are several advantages of HSAs that include:
- Pre-tax contributions: contributions are made with pre-tax dollars and are not included in your gross income.
- Tax-deductible After-tax contributions: Contributions made with after-tax dollars, can be deduced from gross income on tax returns.
- Tax-free withdrawals: Withdrawals from an HSA are not subject to federal taxes and, in most cases, state taxes as well. Withdrawals must be used for qualified medical expenses.
- Tax-free earnings: Interest made within an HSA account is tax free
- Annual rollover: Year over year, any money left in your HSA account rolls over
- Portability: Money in an HSA stays available, even if you change health insurance plans, work for a different employer, or retire.
- Convenience: Payments using an HSA area easy as most issue a debit card. This allows you to pay for prescriptions right away or make payments over the phone using your debit card.
- Start accumulating taxable assets in brokerage accounts, dividend reinvestments plans, mutual funds, real estate, and other cash-generating assets.
By focusing on the items above, you can start to gain ground on your financial journey. You will be doing several things including:
- Minimizing your tax bill
- Reducing your debts until they reach zero. At that point, your cash flow increases significantly, and you have a greater sense of freedom.
- Creating bankruptcy protected retirement assets
- Employer sponsored 401(k)s have unlimited bankruptcy protection, while Roth IRAs have $1,362,800 in bankruptcy protection.
- Only investing in riskier assets when you have a strong financial base. Investing in taxable assets is last on the list above for a reason. Put your money in other areas before you invest in riskier taxable assets.
Do what is right for you.
The advice above is only a suggestion. From a technical standpoint, it makes sense to invest instead of paying down debts if you are earning a higher rate of return by doing so. Even the advice from many financial advisors is only a suggestion. It shouldn’t be followed to a ‘T’ if it doesn’t fit your risk tolerance or live style.
Many people prioritize being debt free as the most important. The FIRE community especially advocates for eliminating your debts first and that is okay. This is an emotional decision, and everyone is going to be different. Many people who are risk averse will favor paying off all their debts first. Or if your debt is affecting your peace of mind, it might make more sense to get rid of it, instead of investing right away.
No one is going to make the right decision for yourself, except you. You can prioritize your financial situation however you so choose. If debt doesn’t bother you, it probably makes for sense to invest, as long as you are earning a higher return. On the other hand, if debt is keeping you up at night, you might want to pay it off before investing.
With hard work and persistence, you will be able to reach the endgame of financial independence, which is having no debt and an abundance of wealth generating assets. This will provide you with a comfortable standard of living for you and your family. But in order to get there, you will have to make a tough decision and factor in behavioral economics. You must decide if paying off debt or investing is more important to you. And again, that is only a decision you make for yourself.