Ever since the recession a few years ago, many Americans have become adept savers. Like the Depression of the 1920s, the feeling of financial insecurity left consumers with an almost irreversible fear of experiencing that kind of stress and instability again. However, along with the need to save and invest came the need to pay down debt, as Americans had a record amount of personal debt.
These opposing forces led to a dilemma – should you save or pay off debt? Or for some who didn’t want to earn a meager 0.05% from their savings account, should I invest or pay off debt? Below, we discuss the pros and cons of paying off debt versus saving and investing, and the different situations in which it makes sense to prioritize one over the other.
Type of Debt and Interest Rates
The simple answer is – it depends. Whether you should invest or pay off debt is determined by the type of debt and the interest rate or cost of debt. When making any financial decision, the answer can be found with simple math and research.
Between 1900 and 2014, the stock market returned over 11%, on average. If you think about it, this period includes a deep Depression, multiple recessions, two World Wars, the Vietnam and Korean wars, Oil Embargos, terrorist attacks and a number of boom and bust cycles. This time period has not been cherry-picked.
For a more recent data set, we can use 2007 to 2014, during which the stock market averaged more than 9% annually. The bottom line is, over a long investment horizon, let’s assume you can expect your investments to average roughly 10% per year.
Mortgage Payments
Armed with this knowledge, would it make sense to pay off a 30-year mortgage with an interest rate of 4%? Even if you weren’t lucky enough to refinance with ultra-low interest rates, there is no way your mortgage rate is close to 10%. Given that you only have a finite amount of cash and must allocate your funds to maximize your returns, investing in the stock market, even with little money, will yield a better return than paying off your mortgage early.
Credit Card Debt
However, investing shouldn’t always be your go-to use of cash. If you have high-interest debt, such as credit card debt or a payday loan, it is likely best to pay off that debt first. While the idea of becoming an investor can be exciting, earning 10% on your savings while paying 30% on your debt is one of the worst things you may do to your net worth.
On top of the fact that your debt requires you to pay more interest than what you may be earning on your investments, it is also likely that the amount of your debt significantly exceeds your savings. For example, it’s bad enough to have 10% coming in while paying out 30%, but if you have $5,000 in savings and $10,000 in debt, you are simply compounding your problems by going further in debt. In cases like this, pay off your high-interest debt before investing.
Student Loans
Student loans are a bit trickier. As an undergraduate, you likely had access to low-interest student debt or maybe consolidated that debt after graduation into a federal loan with roughly 4 or 5 percent interest. Given the flexible, long-term nature of student debt, you should simultaneously invest and pay it down, all the while taking advantage of the tax write-off for student loan interest.
On the flip side, if you are a parent or grandparent who took on education loans for their children or grandchildren and are being charged high single-digit interest rates before retirement, it would behoove you to accelerate payments and wipe it out. This is because, as you prepare for your retirement, your portfolio shifts from high-return, high-volatility equities to low-return, low-volatility bonds and Treasuries. That 10% average return we discussed earlier is likely not going to apply to your portfolio, and those student loan payments are going to kill you in retirement, especially as you live on a fixed income.
Don’t Forget Your 401(k)
You may already be investing a portion of your income if you have a 401(k). Because corporate 401(k) plans are tax-advantaged, you should be contributing to your account as soon as you are eligible. And if your company offers an employer match, then you better make sure you are earning every additional dollar in compensation.
If you have access to a 401(k) and are actively contributing to it, then you are already investing a fair amount and may consider focusing your after-tax dollars into paying off debt. Alternatively, you could fund an IRA, private portfolio, invest in real estate, or start a side hustle. But no matter what you do, don’t invest in life insurance.
Do What’s Right For You
Everyone’s financial circumstances are different, and while experts and bloggers can offer overarching advice and tips on how to manage and grow your income and personal balance sheet, you must decide what is right for your goals and needs. Reading, researching and analyzing your decisions is critical to building your financial literacy and skills.
While the decision to save and invest or pay off debt can be a challenge, know that whichever you choose, you are on the path to financial independence. Ultimately, either option is better than wasting your money on material possessions or taking on non-investment debt.
John Schmoll and Gary Dek are former finance professionals who are committed to helping investors make smart investment decisions. You can read more of their insights at Best Discount Brokerages.
There’s nothing that says you can’t do both. Start a 50/50 split with your extra income and see how things go. At a certain point, you may see more impact or get more passionate about one versus the other, at which point you can certainly make adjustments.
That’s true, Money Beagle – I like your perspective of making adjustments along the way – thanks for stopping by!
I’m kind of facing that too. I would like to pay off the small ish consumer debt I have but it’s zero percent interest for another year. Obviously I want to pay it off by that time, but I should really invest the extra money right now, even though mentally I hate consumer debt.
Be careful of the zero percent though…..if you don’t pay it off by the end of the promotional period you’ll get socked with interest that’s accumulated from the time of the transfer!
Personally I like the idea of knocking out the smaller debts before trying to save or invest. Once you’ve decided to get serious about fixing your finances, I normally coach clients to pay off as much as you can in the first year or two. If that’s all of the non-mortgage debt, great. If not, hopefully you can pay off all of the smaller ones. I know the math may sometimes indicate it’s better to invest first (depending on the rates on the debt, usually), but the freedom of being out of the debt is huge (and unfortunately hard to quantify).
Being serious about improving your finances is the most important factor! Paying off debt and investing will both take care of themselves if you start highly motivated.
Great post.
John
I agree, John – doing *SOMETHING* is the most important. Thanks for your perspective!