One of the biggest decisions you’re going to face when beginning to invest is whether or not to pay off debt first.
Looming credit card debts, student loans and mortgages have large appetites that demand attention and eat away at savings accounts and investment possibilities. A sense of obligation or even guilt can dissuade people from opening an investment account and funding their retirement portfolios.
Your debt’s APR vs. your portfolio’s expected return
The key to figuring out whether it’s more useful to pay off debt or invest can be found by looking at the interest rates associated with either choice.
For example: if you have a $2,500 loan at a 6 percent APR but could invest somewhere else and get a 8 percent rate of return — it would make more sense to invest that money instead of paying off the loan.
The average investor can expect to see long-term returns in a diversified investment portfolio of around 7.5 percent. With that benchmark in mind, we can say that debt with an interest rate higher than that should be paid off, while debt with rates of less than that aren’t worth paying off — unless you’re trying to free up monthly cash flow.
Here’s another example: Mark has a car loan of $10,000 at 5 percent interest for 5 years. He will pay $12,762 over that time. If Mark invests at 7.5 percent instead, he would end up with $14,356 — a difference of $1,594.
Use our Loan Payoff Calculator to see how different payments and interest rates affect your loan.
When to pay down debt first
Credit card debt is the number one reason why people put off investing. This type of debt comes with high interest rates and a small minimum balance that needs to be paid every month, keeping you on a paycheck-to-paycheck lifestyle and unable to save.
In almost every case, paying off the credit card is a better decision than investing and accepting a lower rate of return than feeding the insatiable interest rate on the card.
Investing vs. paying down a mortgage early
While often considered “good debt”, mortgages can still be a hindrance to your investment portfolio.
In these cases, people believe that their houses count as an investment and take on a higher payment than necessary, preventing further diversification. While a house may be a viable part of one’s investments, the bursting bubble of 2008 will tell you that other assets will be needed to maintain a healthy, diverse portfolio.
Other loans such as car notes or student debt generally aren’t an obstacle to investing. As interest rates on these products are typically lower than the returns you could expect to receive on other investments, there’s no urgent need to pay these off first. These loans come with an amortization schedule, unlike revolving debt such as credit cards, which means payments are easy to anticipate and not subject to rate changes.
A note about student loans — interest rates temporarily spiked to 6.8 percent in July, necessitating a change in college planning. While a bill was passed that returns the rate to 3.9 percent, there is little doubt that rates will rise over the next year. The positive takeaway is that the interest payments on student loans are a tax write-off.
Starting an investment account is an important step in your financial future, and debt shouldn’t take center stage. There is a certain psychological benefit in knowing that you have begun to invest and even in instances where debt exists, it’s not wrong to set up a small monthly deposit account in a mutual fund to get things started.
How do you decide between paying off debt and investing?