- Life & Money
- Everyday Money
- Managing Debt
- Tim Stobierski
- May 26, 2022
Should You Pay Off Debt or Start Investing? Ask Yourself These Questions
If you’re anything like the average American, you probably carry at least some debt. The Northwestern Mutual Planning & Progress Study found that in 2021, the average American owed $23,325 in debt (above what they owe on their mortgages). What’s more, Americans are spending an average of 30 percent of their monthly income to pay off debt.
of Americans’ monthly budget on average goes toward paying off debt.
Debt can feel like a weight, which can lead you wonder: Should I aggressively pay off my debt or start investing for the future?
“For many of us, it isn’t going to be an either/or answer,” says Jennifer Raess, CFP®, Advice Integration Lead at Northwestern Mutual. “But there’s nothing wrong with working toward both goals at the same time.”
Before we get into some of the considerations here, it’s important to point out that you should always make the minimum payments on all your debts. But if you have additional funds, here are some questions to consider that may help you clarify your financial priorities for those dollars.
What are the interest rates on your debts?
Knowing the interest rates on your different debts will help you prioritize your goals because it give you a clear understanding of how expensive your debt is — and which debts are good versus bad for your financial health. This is especially important when compared with the expected rate of return you hope to earn on your investments, says Raess.
For example, if your debt carries an interest rate of 4 percent per year, but you reasonably expect your investments to earn 6 percent over time, then investing your extra cash might yield higher returns than if you used it to pay down debt. However, if your debt carries an interest rate of 20 percent, then it’s likely smarter to use the extra cash to pay down that debt.
This means that if you carry high-interest debt, such as credit card debt, payday loans, etc., using any extra money to pay down those debts will likely be a smart move.
What is your risk tolerance?
When you use your extra cash to pay down your debt, you’re lowering the amount of interest you need to pay to service that debt versus making just the minimum payment, says Raess.
In investing, there are no guarantees so you have to have a certain amount of risk tolerance. While over the long term, the overall stock market has trended higher over time, any financial professional will tell you that past performance is not indicative of future results.
So if you are particularly risk-averse, paying off your debt might be more attractive to you simply because it is not subject to market volatility.
How much is your total debt?
If you are carrying too much debt relative to your income, servicing that debt may make living an enjoyable life difficult. If you think you may be in that situation, you may want to do some math to figure out your debt load and your debt-to-income ratio.
Then, see how your numbers stack up in the 28/36 rule: Are you spending no more than 28 percent of your pretax income on housing expenses (including any mortgage payments) and no more than 36 percent of your pretax income on servicing your total debt?
Next, figure out your credit utilization rate. This is an important factor in determining your credit score, as it measures how much of your available credit you are actually using. A rate below 30 percent is advised though even lower is better.
If you carry more debt than is recommended by either of these rules, it might make more sense to prioritize debt payoff over investing — at least until you get closer to the recommended amounts.
How stable is your career?
If you’re not concerned about losing your job, then you might be comfortable carrying a larger debt load because you’re confident in your ability to continue making payments over time. Depending on your answers to the questions above, you may prioritize investing over debt repayment.
But if you work in an industry or at a company that is undergoing some turmoil or, worse, contraction, you might face the risk of losing your job, hindering your ability to repay your debt. In this case, paying down your debt instead of investing could help you reduce your liabilities and give you greater peace of mind.
Are you hurting your financial future by not investing?
If you’re eligible to contribute to an employer-sponsored retirement account, like a 401(k) or 403(b), it’s important to know whether you’re eligible to receive any form of employer match.
“It doesn’t get much better than free money,” says Raess.
If you’re paying down your debt so aggressively that you aren’t maximizing your employer match, then it may be wise to reprioritize your goals. Make sure that you’re contributing at least enough to your retirement savings to claim that match, says Raess.
Define your priorities
Whether you choose to prioritize paying down your debts, investing in your future or both at the same time will come down to your personal financial goals and priorities. A financial advisor can help you see how your debt fits into your larger financial picture and help you strategically balance paying down your debt, while you save for other future goals as well.
Information is provided for educational purposes only and is not a recommendation for any particular investment. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
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