If you recently got a raise or a cash gift, you might be wondering what you should do with it. It could make sense to use it to pay off debt. Depending on how much interest you’re paying, however, it might be a smarter financial move to invest the money instead.
Before you make that decision, you’ll want to crunch some numbers to figure out what your highest return on investment might look like. This article will dive into whether or not you should focus on investing or paying off debt, and will look at specific factors you might want to consider before you make a decision either way.
You should invest if:
Your portfolio’s ROI is high
If you’re on the fence about whether or not you should invest your money, look at your portfolio’s potential return on investment. When your debt costs less to finance than the average rate of return in the stock market, you might want to consider investing your money instead of aggressively paying the debt off.
Let’s say you recently took out a car loan with a 4% APR. Compare that to the average return of the stock market: The Vanguard S&P 500 ETF (VOO) tracks the S&P 500 and provided a 10.92% return for investors over the last five years. With a low-interest debt, you could potentially earn more over the long run by investing in an ETF that tracks the growth of the entire stock market.
You have an employer match
Many employers match 401(k) contributions up to a certain percentage, typically between 3% to 5%. Your employer match is not only free money you can invest with; it’s part of your overall compensation package. Not taking it is like handing a portion of your salary back to your employer. You’ll want to prioritize getting the full match instead of paying down debt.
There’s also a tax benefit to investing in your 401(k) that you’ll want to consider too. Tax-advantaged retirement accounts – like your 401(k) – use pre-tax dollars. Not only can you benefit from your employer match, but fully contributing to your 401(k) can lower your taxable income in the short term.
You want to generate cash flow
Depending on your investing strategy, some investments might be a source of passive income. This could be income from a rental property or dividend payments from certain stocks in your portfolio.
Consider the financial benefits of generating cash flow when investing. If the income you generate is higher than it costs to finance your debt, it could make sense to keep investing. Doing so puts your money to work by creating more money for you in the short term. You can use passive income to pay down debt while continuing to grow your investment portfolio.
You should pay off debt if:
Your debt has a high interest rate
Carrying debt on a high-interest credit card is going to cost you more than the long-term benefits you might gain from investing. According to LendingTree, the average credit card interest rate is 22.40%. Compound interest goes both ways: It can help you build wealth, but it can also dig you deeper into debt.
If you find yourself in consumer credit card debt, you’ll want to prioritize getting rid of it ASAP. To make repayment more manageable, you can restructure your debt by doing a balance transfer to a 0% APR credit card. Alternatively, you can opt for a low-interest debt consolidation loan. Once you’ve substantially reduced your debt’s interest rate and have a plan in place to pay the debt off, then you might consider investing.
You want to boost your credit score
A low credit score can impact your ability to finance large purchases and get out of debt. Around 30% of your credit score is determined by your credit utilization. This tells creditors how much debt you carry compared to the amount of credit you have access to. If you’re constantly maxing out your credit card, this signals to lenders that you’re a high-risk borrower and your credit score can take a hit.
A poor credit score can make it difficult to get a loan with a low interest rate. If you’re looking to finance a big purchase, like buying a house, your credit score can add tens of thousands of dollars to the total cost of your loan. Paying down debt now to reduce your credit utilization rate can boost your score and save you money in the long run.
You want to address the emotional burden of debt
Something important to consider is the emotional toll your debt is taking on your life. While you might be feeling some FOMO that you aren’t investing, the burden of debt can take a much bigger toll on your overall psychological well-being. If your debt is something you lose sleep over, prioritize paying it off as quickly as possible.
P.S. Don’t forget to save some money too
Before determining whether or not you should pay off your debt or invest, make sure you have an emergency fund in place. You’ll want to have easy access to liquid cash in case you need to pay off a sudden expense.
Start with a $1,000 fund for unplanned expenses like car repairs. From there, work on saving three to six months’ worth of your living expenses. This can help if you face a sudden job loss or find yourself unable to work for a period of time.
Should I sell stock to pay off debt?
Selling off stock to pay off debt might seem like a good, quick fix. But depending on the stock, the type of account you purchased it in, and how long you’ve held it, selling it might not be the best idea.
If you’re invested in a company that performs well or pays out a high dividend, it could make sense to stay invested. This is especially true if the financial benefit of holding onto the stock is greater than the cost of your debt.
And you’ll want to be particularly careful if you’re considering selling stock from a tax-advantaged account like your retirement fund. There are penalties for early withdrawals that can eat away at your overall investment.
Consider the tax implications of selling stock too. If you’ve held onto it for less than a year you’ll have to pay short-term capital gains taxes on it. This can wind up costing you more than what you might gain from using the sale proceeds to pay off debt.
Paying down mortgage vs. investing: Which takes priority?
If becoming debt-free is important to you and your mortgage is the only thing standing in your way, there are some things to consider before paying it off.
Interest is front-loaded on your mortgage, meaning most of your initial payments are applied to interest rather than principal. You can pay down your mortgage faster if you prioritize making extra payments at the beginning of the loan. It will reduce the amount of interest you pay overall.
If you’d like to use the equity in your home to do renovations or leverage it as collateral to purchase an investment property, paying down as much of your mortgage as possible can make sense. Leveraging your equity to improve the value of your home or build an investment portfolio can provide long-term financial gains.
There are, however, some tax implications you’ll want to consider before you pay off your mortgage. Homeowners receive a deduction on their mortgage interest payments. Depending on your taxable income level, losing this deduction could increase your tax bill or change your tax bracket altogether.
Some lenders also charge early repayment penalties. Read the fine print of your mortgage to see if this applies to you. Paying down your mortgage can improve your financial well-being, but you might find that paying it off entirely does not.
Summary: paying off debt vs. investing
Before deciding whether you want to prioritize paying off debt or investing, you’re going to want to crunch some numbers. Aggressively paying off low-interest debt or debt tied to an appreciating asset, like real estate, might not be the most financially advantageous move for you. If the gains are higher than the cost of financing your debt, it could be worthwhile to invest at least some of your money while continuing to make your minimum debt payments.
But you’ll want to prioritize paying off debt if you have high-interest credit card balances. This type of debt is not only expensive to finance but can negatively impact your ability to access less expensive lines of credit in the future. This can wind up costing you more money in the long term while also degrading your quality of life in the short term.