Pay off Debt vs. Invest

Most Americans have some form of debt. From monthly mortgages to the ubiquitous ghost of student loan payments, you’ll be hard-pressed to find anyone who’s totally debt-free.

The decision to invest or pay down debt can feel like a delicate dance. If you ignore your debts, creditors will start tacking interest onto your monthly bills, which can begin a never-ending cycle of minimum payments and interest accumulations. On the other hand, every moment you put off investing can mean missing out on the power of compounding interest.

So, if you have $200 in your pocket, what should you do with it? Put it towards your debt or invest it for the future? Is it better to totally pay off all your debt before you begin investing, or should you only pay the minimum balances on your accounts and put the rest of the money into a retirement account or the stock market?

The answer to these questions will depend on your specific circumstances and the type of debt that you have.

Consideration 1: Your debt type

Believe it or not, some debt can be good. For example, most homeowners have a mortgage payment to cover the cost of their home—however, homes are generally considered to be an appreciating asset, meaning that they rise in value over time and end up worth more than the original value of the mortgage. You can deduct interest paid on your mortgage from your federal taxes up to a certain amount, so there usually isn’t a rush to pay off your mortgage if the payments are manageable and you have a steady stream of income.

Interest on student loans is also tax-deductible up to $2,500, and many creditors offer 0 minimum payment “grace periods” to new graduates that can last anywhere from six to 18 months in order to help you focus on securing employment. To learn more about tax-deductible interests, check out the video featured below:

Some debts have no benefits. For example, credit card debt (especially on credit cards with interest rates above 15 percent) and auto payments have no tax benefits and do nothing more than act as a drain on your finances. If you have either of these types of debt, start by paying them down first before you think about investing.

Consideration 2: Your interest rates

High-interest loans have the potential to trap you in a never-ending circle of debt repayment. If you have high-interest debt, you should focus on repaying this first before you begin investing.

As a general rule, the types of debts that incur high interest include payday loans (which can charge up 400% APR), credit cards with over 10% interest, and buy-here-pay-here auto loans and leases. If you have any of these types of debts hanging over your head, pay them down as quickly as possible.

Consideration 3: Your risk tolerance

Younger investors (those who have more years until retirement) have the benefit of time on their side. If you are in your 20s or 30s, you can shoulder more investment risk, putting your money into mutual funds or stocks that have a greater potential for reward. Should the market take a dip, you have enough time to ride out low returns until the bull market comes back again.

However, as you approach retirement, you will want to be more conservative with your investments, placing your money into securities that have less potential for payout.

Look more into asset allocation if you need help figuring out how to balance your portfolio.Older investors may want to focus on paying down debts before investing, while younger investors may see more returns thanks to compound interest. 

Consideration 4: Your employment status

If you’re self-employed or if you work part-time, your income can be highly variable. A single lost client or three fewer hours worked a week can seriously impact your ability to pay down debt.

You can manage this risk by focusing on paying debts first before investing. On the other hand, if you’ve been salaried in your position for years and you’re settled and comfortable in your career, you can reliably predict how much money you’ll have coming in each month, and you’re less likely to fall behind on your bills. In this circumstance, it is better to invest first while also managing money to work towards becoming debt-free.

Paying down debt vs. investing: Where to start with each

If you've decided you're better off paying down debt

The best place to begin is by using what’s called the “debt snowball” method of debt reduction. First, lay out all of your debts in front of you and calculate what you owe on each account. Identify the account with the highest outstanding balance and focus on paying as much as you can towards this debt while also paying the minimum balance on all of your accounts—this will help you avoid accruing additional interest on your debts or lowering your credit score.

After your smallest debt has been completely paid off, move onto your second smallest debt, tackling each account in order from least challenging to most challenging. Though some financial experts advise that you should halt all retirement and investing contributions while paying down debt, this “crisis mode” should generally last for no more than two years—beyond this amount of time, you will begin to lose out on the principles of compounding interest. You can see an example of the debt snowball method below:

If you've decided to begin investing

A great place to start is with your retirement plan. If your employer offers a 401(k) match program, begin by contributing the maximum maxed percentage to your account each pay period. If you are self-employed or you’ve already maxed out your 401(k) for the year, opening a traditional or Roth IRA is a great way to further solidify your retirement savings.

No clue how to start? Take a look at Benzinga’s round-up of the Best Roth IRA Accounts. Here's a quick look at our favorites.

Final thoughts

The decision whether to invest or pay down debt first is a personal one. However, regardless of how much debt you’ve accrued, get started investing as early as you’re able.

Even if you aren’t quite ready to jump into investing today, educate yourself by reading up on the domestic and international markets. That can help you make smarter money movements when the time comes.

Want to learn more about investing? Check out Benzinga's guides on how to figure out if you should pay off your mortgage or invest, the best online brokerages and the best investing books for beginners.