Have you ever found yourself asking this very question, wondering what to do next, and what the best option is for your financial success? Don’t be embarrassed if you have. I would dare say that you’re in good company, given the fact that Americans collectively owe $1 trillion in credit card debt. In fact, the question of whether to invest or pay down debt is one that I’m asked frequently by clients.
Logic is Always 20/20
Trying to tackle debt while still trying to save and invest can be tricky. But, when you think in terms of pure numbers, pure logic, the answer to this question is actually pretty simple. Ask yourself which number is greater, the return on your investment or the interest you’re paying on your debt. If you’re paying more interest than you’re earning, paying off your debt is the smarter choice.
Here’s one way I explain this to people when they ask me whether they should invest or pay down debt:
If you eliminate debt that you’re paying 15% interest on, that’s a guaranteed 15% return in your pocket. If you invest, you may have the possibility of earning 10%. So, what’s better for you to capture right now – a guaranteed 15% return, or a possible 10% return?
Numbers and logic make this a no-brainer. But it’s not always that simple, because money is emotional.
The possibility of earning big will usually tug at your heartstrings harder than paying off your debt. Plus, saving into your investment account gives you a sense of future security and accomplishment. Paying bills is stressful and not what you “want” to do with your money.
Good Debt vs. Bad Debt
To be able to truly answer the question of whether you should invest or pay down debt, you have to understand all of its components.
That includes categorizing your debt into good debt and bad debt, and understanding how they affect you. This is the first step in creating a debt strategy that works for you.
Here’s a basic guide to help you discern what portion of your debt is good and what portion is bad:
Bad Debt (credit cards, car loans, unsecured loans, etc.):
- It has high interest rates.
- It’s not tax deductible.
- It’s not attached to appreciating assets.
Good Debt (mortgage):
- It has low interest rates.
- It’s tax deductible.
- It’s attached to appreciating assets.
Good debt is an interesting topic. It’s worth pointing out that most private equity and real estate firms build their empires by leveraging almost everything they have. People do this in a similar way. Why wouldn’t they, given that the market and other appreciating assets are out-earning the current interest rates?
For instance, the ticker SPY for the S&P 500 has returned 7% for the last 20 years. In comparison, our all-equity ETF portfolio has an average back-tested return of a little more than 9%. That means in 20 years, $10,0000 becomes $58,474.
Your 4-Step Action Plan
Given all the factors we’ve discussed here, there’s probably one thing you’re thinking right about now – Great, but where do I start?
You should start with the following four-step action plan. We use this with our clients, and strive to approach their financial life in the following way:
1. Build core liquidity. You should have a minimum of 3-6 months in liquid cash. It would even be wise to have 6-12 months of near-liquid assets on hand as well.
2. Eliminate bad debt. Again, that would be any substantial amount of short-term debt that may have high interest rates.
3. Save 15% of your salary. With $1 trillion in credit card debt weighing on Americans, it’s no wonder that the average savings rate has plummeted to just under 6%. But if you can’t save, everything else has to work harder to pick up the slack. A healthy savings rate of at least 15% is critical to reaching your full financial potential.
4. Invest. Investing is critical to your success, but should only be done when you’re in the right position to do so.
5. BONUS! Have an ideal mortgage to income ratio. Your mortgage payment should be no more than 15% of your gross income. Otherwise, you may wind up house-poor down the road.
This action plan takes a “priority and combination” approach to your financial life. Put simply, this approach focuses on securing your liquid safety net first, paying off bad debt, and finally investing. Once you have your core liquidity built up, you can then use your 15% savings to accelerate your debt pay off. I recommend this approach because it allows you to pay off your debt, and eventually invest, while still being able to adapt to life’s changes.
In other words, you’re not completely sacrificing one important element (i.e. savings) just to take care of another (i.e. paying off debt).
Why Does It Matter to You?
Numbers make the answer to whether you should invest or pay down debt pretty simple – if you’re paying out more than you’re earning, investing may be an act in futility for you right now. But as we’ve shown here, that’s not all this question asks you to consider.
This question is about more than just numbers – it’s about prioritizing your financial life in a way that makes your money work for you. A way that makes your money work as efficiently as possible. That means having six months of liquid cash built up, paying off any substantial bad debt, and then investing. There’s no one-size-fits-all timeline for the action plan we’ve outlined here, either. However, it’s important to remember that the longer you delay investing and compounding your savings, the less time your money has to grow. That can mean a diminished lifestyle in retirement.
When you look at the big picture, debt directly affects your ability to save, invest, and ultimately live the life you want. Start tackling it now, and you can find yourself much better off in the future.