Debt Versus Investing: A Simple Solution!

For today’s guest post on debt versus investing, please welcome Jeff from Have Your Dollars Make Sense.

So I have often thought about and read about the idea of which is better when it comes to debt versus investing. Pay down debt or invest. This comes up a lot in forums, blog posts, etc. It seems to be a perpetual question and I get it. Who wants to be sitting in debt!? Being a slave to the man! That’s a big no for me. Debt flat out sucks and it can definitely limit all future choices… but on the other hand, we all want to build our net worth. We all want to build wealth. We don’t want to funnel all our cash into debt when it could potentially be earning more in capital gains in the market or elsewhere. So what to do… what to do?

Money gradually growing into more, as it does when paying down debt or investing

Debt Versus Investing

Max out all 401(k)s if there is a company match available

First off, max out all 401(k)s if there is a company match available. Free money is free money, right? Consider maxing out IRA accounts too due to the tax savings (if you make less than $117,000 as a single filer or less than $184,000 if married) and the beauty of the backdoor IRA otherwise. Okay, now that we have that out of the way, what about debt versus after-tax investments accounts?

Well in some ways deciding if and which debt to pay is easy. If the debt is high interest, which I would qualify as over 6%, then pay it off! Get rid of it! Imagine that it is some hot oil sitting on your skin, waiting to be lit on fire. It is no good and needs to go away; not today, not tomorrow, but yesterday. Obviously credit card debt falls into this category and should be paid down first. Investing is great, but returns during any short-term period are not guaranteed, the interest on your debt is.

After credit card debt, it is possible some of our readers have student debt in the 5% to 6% range. My wife did. If you graduated in the late 2000’s then interest rates had started to creep up and lenders took full advantage of all the people who wanted to go to school. It still astounds me that lenders can get away charging more in debt (subsidized by the government) to get an education than if you buy a home or car. So take a look at all of your debt, determine what is accruing interest at over 6% (or 5% if you want to be conservative) and pay it off. Don’t think about investing in “after-tax” accounts until this is done.

Now comes the harder part

What about debt that is lower than 5% or 6%, a.k.a. lower than expected returns in the market? Some will say just pay down the debt. Get rid of it and don’t be a slave to any lender or job. There is some wisdom to this and it’s hard to argue it is a bad path. Others would argue: invest it all in the market, as you will likely earn more over the long run then you will have to pay in interest. If you have a loan at 4% interest and you earn 7% in the market, then you are up 3%. This makes sense! It’s relatively simple math.

There is no right or wrong answer

In the end, neither paying off debt or investing is a bad idea, but you need to aggressively be doing at least one of the two. Your money should be put to good use and not wasted by spending on unnecessary purchases. Better yet, go full throttle on both if possible. In the end, do whichever will lead to less stress going forward. If paying off debt is your thing, then pay it off and don’t worry about the returns you could have earned. You never know when the market may crash again and then you would have wished you paid down your debt instead of invested in the market. If you want to see the money pile up, then save and invest and pay down the debt slowly.

What about another option?

Okay, so this next plan is what I did before I wanted to be debt free. Take the amount of extra money available at the end of the month for investment, let’s say $1,000, and do the following: invest 70% in the market and take the other 30% to pay off lower interest debt (remember less than 5% interest). In essence use debt pay down as safe investment or bond-like allocation. The debt pay down is a guaranteed return of 3% or 4%. This plan is good for the individual looking to pay down some debt and invest at the same time.

So here is the breakdown

  • Max out 401(k)s to ensure you get a company match. Consider contributing to an IRA.
  • Pay off all high interest debt (5% or 6%)!
  • Decide what to do with your extra money. Let’s say the hypothetical $1,000 a month.
    • Plan 1: Pay $1,000 a month towards debt until it is all gone.
    • Plan 2: Pay $1,000 a month towards investments. Choose your allocation and stick to it.
    • Plan 3: Take the $1,000 and place 70% ($700) towards aggressive investments (stocks) and 30% ($300) towards debt payment. Feel free to play around with this allocation. Go 50/50% or 40/60%. Whatever works for your family.

So what do you do regarding debt pay down versus investment? Plan 1, 2 or 3 above?

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