Which should you do first? Pay off Debt or Invest?

With the state of the stock market and the economy, I have a few people reach out to me if they should pay off debt or invest at this time.

This decision can be overwhelming, especially with the ever-present fear of missing out (FOMO) when it comes to investing. You often hear people on social media say “THIS IS THE BEST TIME TO INVEST“, “don’t miss out on the dip“. Lets break it down and help you understand the best approach for your financial journey.

Why the “Invest to Pay Off Debt” Idea Often Fails

Some people believe they can invest their way out of debt, assuming their investments will generate high enough returns to cover what they owe. But this approach often falls apart. Here’s why:

Investing Isn’t Guaranteed

Unlike debt, investments don’t come with guarantees. You can lose money quickly in the stock market or other investments. Debt, on the other hand, is a guaranteed liability. You have to pay it off eventually.

Investing is a Long-Term Game

Investing is usually a long-term strategy. You might not see significant returns for 10, 15, or even 20 years. Paying off debt, however, offers immediate benefits. Every payment you make reduces your balance and saves you money on interest.

“Good Debt” vs. “Bad Debt”: A New Way to Look at It

You’ve probably heard the terms “good debt” and “bad debt.” Some people think that there’s no such thing as good or bad debt and that all debt is bad. The times we may consider Debt as “good” if it has the potential to increase your net worth or significantly enhance your life. However, in general, I think that all debt is bad (some are just worse than the others)

Think about a mortgage. You might consider it “good debt” because of the relatively low interest rate and long repayment term. But when you pay on a mortgage for 30 years, you often end up paying twice the original price of the house!

Think of student loans. People may consider it “good debt” because it has the potential to give you a salary but if you chose a degree that does not provide you with a good paying job after you graduate, it can be a “bad debt” and you’re stuck paying off student loans.

The “Worst Debt” Category [or the bad debt]

“Worst debt” is the kind you want to get rid of ASAP. It includes:

Debt to Friends and Family: This debt doesn’t come with interest, but it can damage relationships. The emotional cost can be high. I honestly think of debt I give out to family or friends as soemthing that you give out for free.
High-Interest Debt: This includes payday loans and credit card debt. The high interest rates make these debts incredibly difficult to repay.
Tax Debt: The government has the power to garnish your wages to collect unpaid taxes.

The “Bad Debt” Category (Typically Called “Good Debt”)

This category includes mortgages and student loans. While these debts often have lower interest rates and longer repayment terms, they can still be harmful if you’re not careful.

Two Approaches to Tackle Debt and Invest

Your strategy for paying off debt and investing depends on the type of debt you have. Here are two approaches to consider:

Approach #1: The “Worst Debt” Focus

This approach is best if you have both “bad” and “worst” debt.

Step 1: Build a Minimal Emergency Fund Start by saving one month’s worth of living expenses in an emergency fund. This is less than the typical recommendation of 3-6 months, but it allows you to focus on debt payoff.
Step 2: Lifestyle Changes – Aggressively Attack Worst Debt
Step 3: Prioritize Debt Payoff with One Exception Throw all your extra money at your “worst debt.” The exception is your 401k. If your employer offers a matching contribution, invest enough to get the full match before paying off debt. Why? Because employer matching is a guaranteed return on your investment. For example, if you invest $100 and your employer matches $50, that’s a 50% return!

Approach #2: Balancing Bad Debt and Investment

This approach is for people who have eliminated their “worst debt” and only have “bad debt” like mortgages or student loans.

Consider Your Timeframe –Think about how much time you have left on your loan. With mortgages, interest payments are usually higher at the beginning of the loan term. This is due to the amortization schedule. As you get closer to the end, more of your payments go toward the principal. If you’re nearing the end of your mortgage, it might not make sense to pay it off faster because you’ve already paid most of the interest.
Look at interest rates – There is an unwritten rule that if your interest rate is less than 7%, then sometimes paying the minimum off and investing the rest of your money is better. Why? Because if you’re investing long term, the average stock market returns is around 8-10%. Most student loans fall on this category. There are also a lot of student loan repayment programs or loan forgiveness available for healthcare workers that you need to look into.

Psychology and Commitment

Don’t underestimate the psychological aspect of financial decisions. If paying off debt motivates you more than investing, prioritize debt payoff – even if the numbers suggest otherwise. The most important thing is to choose a strategy you’re committed to.

I couldn’t have peace of mind with my student loans so I made a priority to pay if all off in 2020. So consider this when it comes to prioritizing paying off debt or investing.

Important Note on Investing

When discussing investing, we’re talking about traditional index fund investing. This is different from speculative “gambling investing,” where you invest in high-risk, unproven ventures. If you want to learn about this strategy of investing, check out Investing 101 for nurses to learn how.