Should You Invest or Pay Down Debt First?

Hello everyone and thank you for joining me. I'd like to talk with you about one of the most debated topics in personal finance: the decision to invest or pay off debt. When paying off debt, you're effectively locking in your return, with the interest rate being that return. And depending on what that interest rate is, you could either be giving up effectively free money or saving yourself years in payments. All of which exists on a spectrum. So today, I'd like to help give you a framework to help you decide what to do with your hard-earned dollars.

Let's first start with when it may make sense to not pay it off ahead of schedule. To pay off debt, the money needs to come from somewhere, likely a savings account. With money market funds and treasury bills currently earning 3 and 1/2 to 4%, that is a fairly defined line in the sand. By choosing to pay off low interest debt sooner, you lose the flexibility and liquidity and possibly your buffer as well. And with no buffer, if something were to come up, that could put you back in debt at potentially a higher interest rate than before.

Which brings me to the area of consideration. The gray area. If your debt has an interest rate in excess of what you can earn on your short-term funds like savings, but perhaps below what you can earn over the long run, you're faced with a choice. Do you take the guaranteed payment to pay off the debt? Or do you allow those funds to stay invested, with the need to then have a long-term mindset? On average, diversified portfolios with different blends of stocks and bonds have returned anywhere from 6% to 8% over the long run. But as we know in investing, to participate in the long-term returns, we must endure many short-term setbacks along the way. For some, this potential need to be patient in leaner market years, combined with the antsiness to pay off debt, may simply be too much, and they opt to pay it off. For others that want to keep the funds invested, if the interest rate on your debt is anywhere between 5% to 8%, it's your call on what you'd prefer to do.

Now, what if the interest rate on your debt is greater than the long-term average return of the market? Well, then this one is simple. Pay it off as aggressively as possible. And here's why. Just like the power of compound interest grows your wealth, the power of compound interest grows your debt, as well. Data from the Federal Reserve cites the average annual credit card interest rate is just north of 22%, a guaranteed 22% for that matter. If a borrower with a $10,000 credit card balance applies $250 per month, it will take them just over 6 years and $8,000 in interest to pay off the debt, compared with someone making $500 payments per month, where it takes just over 2 years and $2,500 in interest. Twice the monthly payment, far more than twice as effective.

So, now what? First, start by reviewing the interest rate on your debt. It may make sense to hang on to it, get rid of it as soon as possible, or something in between. And then consider the impacts to your long-term financial plan, and ask yourself these questions. How would you go about paying off the debt? What are the trade-offs to paying it off aggressively? Where would you reallocate the excess cash flow once it's paid off? And while life is not lived in the spreadsheet, we hope you find these rules of thumb helpful as a starting point. Thanks for watching, and until next time.