You’ve discovered the world of investing and you feel ready to get started but you still have debts to pay. What to do depends on your situation.
Do millionaires pay off debt or invest?
If in doubt, let’s check what rich people do! This is just to offer a counter-factual to those that say you must always pay off the debt first. Millionaires have debt and investments. So if you’re asking “Can I pay off debt and invest at the same time?” – the answer is yes! BUT it depends on your individual situation.
The Dave Ramsey approach to debt & investing
Dave Ramsey is one of the best-known American personal finance gurus and his ‘7 baby steps’ to get out of debt and build wealth are excellent. Ramsey takes a pretty hard-line approach to paying off debt – it’s the number two step after saving $1000 for an emergency fund. His exception to the rule of paying off all the debt is a mortgage. There is a lot to be said for the simplicity of just focusing your energy on paying off debt, then moving on to investing. Simple things are easier to stick to.
Difference between investing and paying debt
Before we move onto the checklist, let’s establish what we are talking about.
Debt = a liability. You have borrowed money and will have to pay back more than you borrowed because of interest on the debt. The goal is to use debt to buy something you can’t afford.
Investment = an asset. You have bought something with your money that is supposed to either go up in value or provide an income. The goal is to use investing to end up with more money than you started with.
From this you can deduce that you want to decrease the former and increase the latter. The questions is where to sell and invest at the same time, pay off the debt first or even sell your investments to pay off the debt.
NOTE: When you make investments, the returns are not guaranteed. Some investments are safer than others, but you can never be 100% sure. When you have debt, you have to make the repayments – otherwise you default. In this sense, paying off debt is risk-free, while investing is risky.
Read our blog on how to start investing, if you are interested to learn more.
Considerations for when to invest before paying off debt
Are you in a situation where it’s best to pay off all your debt first, or do you have some leeway to invest too? Consider these seven points…
1 Do you have an emergency fund? 💵
Paying back debt and investing are both a means to improve your state of financial stability. But before either of these two activities should even start, it’s important to have an emergency fund just in case you need some cash on hand. Unexpected illness, broken down cars etc will be a lot less stressful if some funds are available to cover them without dipping into investments or adding to debt.
2 How much debt do you have? 📊
When looking at how in debt countries are, economists use Debt: GDP ratios. It’s the same principal for us individuals. We should look at our debt: income ratio. The logic goes along the lines that, if you have a large debt, this needn’t be a problem if you have a large income. But a large debt with a small income is definitely a problem.
You calculate the ratio by dividing your total debt owed by your pre-tax annual earnings. A rule of thumb is that a ‘healthy’ debt to income ratio should be less than 30%. If your debt exceeds this, you should focus on bringing it back down rather than on your investments. If your debt is under 30% of your income, investing is a possibility. The red alert debt: income ratio is 100% - at this level you will be struggling to make minimum payments and will be one emergency away from major financial difficulties.
3 What is the APR on the debt? 📈
This quite a simple point that gets missed by many. You need to compare the interest rates on your debt versus the expected returns you will get from your investments. If you have a low interest rate car loan of 3%, and you have the opportunity to invest in a great opportunity that could double your money- the investment could make more sense. However, if you have a credit card with an APR of 20% and the alternative is investing in a mutual fund that makes 4% per year, you’re better off paying off the card. Think of it like paying off the balance on your debt means you gain the interest you would have paid for servicing it.
4 What type of debt do you have? 💳
Not all debt is created equal. Some debts can be a useful financial tool, others are wealth killers!
Pay off credit cards or invest?
It’s almost always better to pay off credit cards before committing any serious amount of money towards investments. Aim to pay off your credit card every month, and if you can no longer afford to- the first step is to turn to your budget and reduce your expenses.
Pay off student loans or invest?
Student debt is a burden that it is important to get rid of. It’s possible to make the argument for doing some investing and using the returns to pay off your student loan faster – but this means you miss out on one of the most important elements of investing – compound interest. The idea is to leave your money in the investment so that each year there is a bigger sum invested earning returns because you reinvested returns from previous years.
Pay off mortgage or invest?
The generally accepted advise here is to contribute small amounts to a retirement account for your ‘safest’ investing while focusing most of your energy on paying off the house. Having a mortgage limits the amount of risk you can take, so very active risky investments will normally be unwise while you still don’t own your own house.
5 Is the debt for an investment? 👔
Without over-embellishing too much, this is one of the main ways ‘the rich get richer and the poor get poorer’. Once you have wealth and assets, you have much better credit and you can obtain a loan much more easily.
For example, you can buy a rental property as an investment. The cost of the mortgage might by 2% per annum but the rent you can charge the tenants might be 10% more than the cost of your mortgage. On this investment you will be making an 8% return per year before expenses. You could say this is ‘clever debt’ – it is being used to buy an asset that earns you more money than the amount you need to repay on what you have borrowed. However, imagine a person without money or a good credit score likely doesn’t have the necessary down-payment for the mortgage, or if they do, the rate of interest might be similar to the rent you would have to charge, making the investment unprofitable.
6 Can you refinance your debt? 🔣
Depending on your credit score, it might be that instead of paying down the debt, you can refinance the debt to a lower percentage. Sometimes a 0% balance transfer is available. As we’ve already mentioned, a lower cost of borrowing could make an investment with a higher potential return more attractive.
7 Is the debt making you anxious? 😱
Here we are saving one of the most important points until last. Everybody has a different tolerance for debt. If your debt is making you miserable, pay it off quickly. If that means pausing your investments, it will be worth it for the peace of mind. Likewise, if you have some debt but you feel like the situation is under control, this gives you the emotional freedom to pay off the debt at a slightly slower pace and do some investing.
Conclusion: Is paying off debt worth it?
Here is that checklist one more time in simplified form, go though it and see what’s best for you.
- Do you have an emergency fund?
- How much debt do you have?
- What is the APR on the debt?
- What type of debt do you have?
- the debt for an investment?
- Can you refinance your debt?
- Is the debt making you anxious?
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