Should I Invest in the Market or Pay Off Debt?
Everyone has different circumstances, but there are some common variables to examine, including:
- Expected return on investments
- Interest rates on debts
- Tax benefits associated with your debt
- Tax benefits associated with investing
- Matching contributions
- Private mortgage insurance
- Variability of your income
- Number of years to retirement
Evaluating these variables can help you arrive at the optimal solution from a purely mathematical perspective. However, the decision is based as much on your personality as it is the math. After all, we don't live in a spreadsheet.
Some people will prefer paying down debt to capture a lower, but knowable, return. Others will prefer to invest in order to capture higher, but less predictable, returns.
Neither approach is necessarily wrong. For some people, reducing debt provides a greater sense of flexibility and peace of mind. Others are comfortable carrying manageable “good debt” while prioritizing long-term investing. Understanding your own priorities can be just as important as understanding the math.
How to Prioritize
Even if there is no one-size-fits-all advice, below is one framework for how to prioritize investing and debt payment decisions.
Note: Before focusing on either investing or paying off debt, it’s worth ensuring that your emergency fund is adequately funded. Maintaining cash reserves can help provide flexibility when unexpected expenses arise without derailing a new saving/investing strategy.
1. At a minimum, make contributions to your company’s retirement plan up to the level at which your employer matches. Failing to do so is like turning down free money.
2. Pay down high-interest debts with rates that are high relative to your expected return on investing that are not tax deductible. An example might be a credit card.
3. Make the maximum contributions to tax-advantaged accounts such as employer retirement plans, IRAs, HSAs, and other accounts available to you.
4. Pay down debt in which you are paying private mortgage insurance (PMI).
5. Pay down debt with high interest rates relative to your expected return on investing and is tax deductible, such as a high interest rate mortgage.
6. Make investments in investment accounts that are expected to earn returns greater than the interest rate on remaining outstanding debt.
7. Pay down debt with interest rates that are low relative to your expected return on investing.
I find this framework helpful because the core question isn’t as simple as “pay down your credit card or flood a brokerage account with cash.” There’s more nuance and layers of options that could depend on your company benefits or financial situation.
In short, comparing the decision to pay off debt or invest often involves balancing known and unknown outcomes. Paying down debt produces a predictable reduction in interest costs based on the interest rate, while future investment returns are uncertain.
Investing, however, may allow compounding assets over time, particularly when contributions are made to tax-advantaged accounts. Understanding that tradeoff can help provide context when deciding where excess cash flow should be directed.
The answer is never exactly the same for everyone. Factors such as credit card debt, available cash reserves, progress toward building an emergency fund, investment time horizon, and personal comfort with debt can all influence the decision.
Finding the Right Balance
Assuming regular minimum payments are being made and an emergency fund is in place, contributing to tax-advantaged investment accounts may provide a meaningful long-term benefit. In other situations, paying off debt, particularly high-interest debt, may be a higher priority.
It is also worth remembering that this decision does not have to be all or nothing. Some individuals choose to divide excess cash flow among several priorities, such as increasing retirement contributions, paying off debt, and adding to a savings account. The appropriate allocation often depends on interest rates, financial goals, and personal preferences.
