You know investing is important and that paying off debt is too. But which should you do first, invest or pay off debt?
We have to make choices relating to personal finance every day, but we usually know what the right choice is even if we don’t really like it.
Should I use my credit card to buy that new iPhone or save up until I can buy it with cash (you should still use a credit card because it will give you certain buyer protections, just pay off the full amount when it’s due)?
Should I buy shares in the stock my dodgy brother-in-law promised me was a “sure thing” or leave my money in an index fund?
But some personal finance decisions are less clear, maybe none more so than whether it is better to invest or pay off debt. The longer we wait to invest, the less time we have to use the power of compound interest to grow our money. But our debt is costing us money every month.
So what should you do, invest or pay off debt? Well, like most things in life, the answer isn’t always clear cut so we’ll examine a few situations and help you come to the right answer for you.
A 401k is an employer-sponsored, tax-advantaged retirement investment account. If you opt to participate, every month, money will automatically be deducted pre-tax from your paycheck and invested in the fund you select from the choices your employer offers.
401ks are great for a few reasons. They are an easy way to start investing since your employer (typically the Human Resources department) does most of the heavy lifting.
They choose the funds, and all you have to do is select one and fill out a little paperwork. They allow you to invest without feeling like you’re making a sacrifice because the money is taken out of your check before you see it.
These accounts are also an excellent method of “forced saving” since you never get a chance to spend that money.
Because your contributions are pre-tax, having a 401k can lower your taxable income. If you make $50,000 per year and contribute $10,000 to your 401k, you will only be taxed on $40,000 rather than $50,000.
Some employers offer to match which means the employer contributes a certain amount to your 401k based on how much you contribute. One example is a 50% match up to the first 6%.
For each dollar you contribute, your employer contributes fifty cents up to 6% of your gross salary. If you make $50,000 and contribute 6%, ($3,000), your employer will contribute 3% ($1,500).
This all sounds great, doesn’t it? So because investing in a 401k is so advantageous, even those with debt should invest right?
Yes, if your employer offers to match, everyone should invest the minimum required to get the match, no matter how much or what kind of debt they have. Why? Because that match is free money. There aren’t many (or maybe any!) investments where you can invest $3,000 and get $1,500, a 50% return!
If your employer doesn’t offer to match and you have high-interest debt (more on this coming up), then you should forgo contributing until the debt is under control.
Your Emergency Fund
While an emergency fund isn’t exactly a traditional investment, it is a form of investing. An emergency fund is a hedge against the unexpected.
If your car broke down and needed a repair and you didn’t have an emergency fund to cover it, you could find yourself in a dire situation. If you can’t afford the repair, you might not be able to get to work, and if you can’t get to work, you won’t be paid.
So like a 401k with matching, even if you have high-interest debt, you should still save for a small emergency fund. While ultimately the goal is to have an emergency fund that could cover six months of necessary expenses, just work on accumulating $1,000.
Credit Card Debt
This is the big one. The average interest rate on a credit card is 16.92%. The average return on investing in the stock market is about 10% over time. If you are investing while you have credit card debt, you are losing money.
But because investing is so important, you want to do everything you can to get rid of that credit card debt, and there are lots of things you can do to achieve that.
The first thing you want to do is to try to lower the interest rate on your cards. If your credit score is good enough (you can check it for free at Credit Karma), you may be able to get approved for a balance transfer credit card. These cards have an introductory period during which the interest rate is 0%. The period ranges from six to 24 months.
Once approved for the card, you transfer the balance from your high-interest card or cards to the new card. You may not be able to transfer it all; it will depend on the credit limit of the new card. The new card usually handles the transfer; you just have to provide the credit card account details.
During the 0% period, you can make more progress on paying off the principal because that’s all you’re paying, you’re no longer paying interest too.
If you don’t pay off the full balance before the introductory period ends, the remaining balance will be subject to the new interest rate which will have been disclosed to you when you applied for the card.
Even if you can’t get all of it paid in time, you will still have made progress and saved money on interest.
Again, if your credit score is good enough, you may be able to take out a loan with your bank or credit union or with a peer-to-peer lender like Prosper or Lending Club. You will take out a loan and use it to pay off your credit cards.
The advantage is two-fold.
Rather than keeping track of several due dates each month, you’ll just have to pay this single loan payment (again, if you can borrow enough to pay off all of your cards) and while you still owe money, these loans usually have a lower interest rate than do credit cards so you can pay it off more quickly and spend less on interest.
Most online lenders will allow potential borrowers to see what rates and terms they’ll be offered without making a commitment or incurring a hard credit check (which lowers your credit score a few points) so there’s no harm in shopping around and seeing what kind of deal you can get.
Because you need a certain credit score to qualify for the above options, they won’t be possible for everyone. But there is still a way that you might be able to lower the interest rates on your credit cards.
Call the customer service numbers on the back of the cards and ask that the company lower your rate. You won’t always get a positive response, but you can call back more than once. It doesn’t take more than a few minutes.
If you do get a lower rate, even if it’s just a couple of points, it can save you a lot of money and allow you to pay off your cards more quickly.
Now that we have dealt with our interest rates, we need a plan to pay off our credit card debt. If you just pay off a little on this card and a little on that one, you’re not using your payments effectively. If you have more than one card, there are two ways you can attack them, by balance or by the interest rate.
List your debts according to the dollar amount, lowest to highest. Pay everything you can on the smallest debt until it’s paid off while paying no more than the minimums on the others.
Once you have paid off a debt, use the money you were paying on it to pay off the next one while paying just the minimums on the others. You continue this until all of the debts are paid.
The second method works the same, but you pay the debts in order of highest interest rate to lowest, it doesn’t matter what the balances are.
The second method will save you the most money because it’s the method that allows you to pay the least amount of interest. But the first method is more satisfying to some because it allows them to eliminate debts more quickly which helps them to stay motivated to pay off the others.
Choose the method that works best for you.
Student Loan Debt
Tens of millions of us have student loan debt, and it can take decades to pay off. What does that mean for our investments? Will we have to wait decades to start investing?
If we wait too long, will we have enough time for our money to grow to such a degree that will we have enough for retirement or will we have to work until we physically can’t anymore?
It’s scary stuff because while you might think you could ask the same questions about having credit card debt, also something millions of people have, there is a key difference.
Credit card debt can be discharged during bankruptcy proceedings (it will ruin your credit for at least seven years, but you can do it) while student loan debt with very few exceptions, cannot be discharged.
So how can we handle student loan debt and investing?
The average rate of interest on a federal student loan ranges from 4.81% to 7.44%. For private student loans, it’s from 7.81% to 9.66%. Remember our reason for not investing when we have credit card debt? Because the interest rate on the credit cards was more than we could make investing.
But most student loans have interest rates below the 10% we make investing. So we should invest, right? Yes, but wouldn’t it be even better if we could lower the interest rates on our student loans? What would be even better than that is if we could have our loans forgiven. Let’s see if we can do that first.
If you have federal student loans, you may be eligible for one of the government’s student loan forgiveness programs.
In most cases, you still have to make payments for a decade or more, but because these loans can be for tens or even hundreds of thousands of dollars, even after making payments for ten years you could still have an enormous balance remaining.
This is a complete list of the forgiveness programs currently offered. Before you do anything else, see if you are eligible now or in the future to participate.
Not eligible for any of the student loan forgiveness programs? Okay, don’t fret, you may at least be able to lower your interest rates.
Please carefully note, if you refinance federal student loans, you will no longer have access to any of the repayment or forgiveness options offered for federal loans. Once refinanced, they will be private loans, no longer federal.
Some student loan refinancing companies do offer some assistance to borrowers who are struggling to make their payments but they are not as comprehensive as the federal loan programs, and there are no companies that offer forgiveness programs.
LendKey is a student loan refinancing company, and they offer interest rates starting at 2.47% for variable rate loans and 3.49% for fixed-rate loans. You might wonder why anyone would opt for the higher of those two, but a variable rate loan is a gamble.
If interest rates rise, the rate on your loan will rise with them. If you have the money to pay your loan off quickly, it might be a risk worth considering. If you’re not a gambling type of person, you’ll probably prefer the fixed rate loan. The interest rate will remain the same for the life of the loan.
Refinancers like LendKey let you see what terms and rates you’re eligible for without doing a hard credit check so again; window shopping won’t affect your credit score.
Because the interest rates on these loans are less than we can make investing, you should invest even if you have student loan debt. If you’re eligible for forgiveness, only pay the minimums on your loans and start investing. Eventually, the loans, interest and all will be forgiven.
If you’re not eligible, refinance to a lower rate and keep doing it. Every time you’re credit score goes up, or your debt-to-income ratio goes down, shop around and see if you can get a better rate than you currently have. There is no limit on the number of times you can refinance.
If you have mortgage debt, you can, for the most part, apply the same criteria we used to decide between paying off student loan debt and investing. The average mortgage rate is from 3.50% to 7.39%, less than our 10% return on investments.
Once you have a certain amount of equity, you may be eligible for a better rate, and you can shop around for refinancing offers. The more equity you have, the better the offers you’ll get.
There is a particular situation though where you should devote extra money to paying down your mortgage instead of using that money to invest. If you didn’t put down at least a 20% down payment on your home, most lenders would require you to have Primary Mortgage Insurance, PMI.
PMI protects the mortgage lender if the borrower were to default on the loan and the home was to go into foreclosure. The cost of PMI ranges from about 0.3% to 1.5% of the total loan amount.
Borrowers may be required to pay it monthly as an additional charge on the mortgage bill, all at once when the home is closed on, or a hybrid model where a bulk payment is required at closing, but it’s not the whole amount and the remainder is divided out between each monthly mortgage bill.
Remember how the money from the 401k matching was money you were getting for nothing? Well, PMI is money you’re paying for nothing. It has zero benefits to you; it is meant to protect the mortgage lender so you want to get rid of it as quickly as you can. Once your loan balance reaches 80% of the original value of your home, you can ask the lender to waive the PMI requirement.
Once the balance reaches 78% of the original value of your home, the lender is required to drop PMI. Once you get the PMI waived, you can stop overpaying on your mortgage and use that money to invest instead.
The Longer You Wait…
The longer you wait to start investing, the harder it is to make up for that lost time. Wait long enough, and it won’t be possible to make up for it, even if you invest a lot of money. The most important part of investing isn’t money, it’s time, and you can’t get it back.
But at the same time, debt can undo any gains you might have made from investing. Get your interest rates as low as you can, and high-interest debt paid off as quickly as you can so you can free up your money to work for you.