When it comes to the age-old question of invest vs debt, many people wonder what to do. Some say invest without looking back. They tout that if the compound interest you can gain by investing is larger than the interest rate on your debt, then it's a "no-brainer." Other people say pay down debt. They mention that a life of no debt is a life of freedom and paying it down gives you a guaranteed return, free from risk. But is it really so black and white? How can two seemingly smart camps of people come to such vastly different conclusions?
When it comes to investing or paying down debt, the right answer depends on a unique set of circumstances and facts that can be ever changing in our lives. Yes, they include math. But they also vary based on our risk tolerance and individual values. Let's take a deep dive and examine this further.
Benefits of Investing
Investing has several benefits. For starters, it allows you to put your money in a position to grow and make a profit. Most people don’t build wealth or even acquire the funds needed to meet their financial goals by just saving. They are usually able to meet these goals investing, whether that’s in the stock market or in real estate or in some other lucrative business venture. The younger you are, the more likely investing will work out in your favor because you have more time for compound interest to turn your investing yield into even greater returns. Although nothing in life is guaranteed, and some investments can fluctuate in value from year-to-year, investing money allows your money to grow and can help you reach your financial goals sooner.
Benefits of paying down debt
Investing has benefits but so does paying down debt. For starters, paying down debt gives you a guaranteed return. Unlike investments that can decrease in value during market downturns, paying down provides certainty. It’s a surefire way to enhance your net worth. Not only does it decrease your liability, but it also helps to free up your cash flow. By getting rid of those monthly debt payments you will have fewer fixed expenses/bills and more money to spend on other things. In addition to more cash flow, paying down debt provides another benefit that can’t be quantified: financial freedom. There is no doubt that people, especially high-income earners, who are debt free, feel psychological freedom. They can leave jobs they don’t like without worrying about how they will repay their student loans. They can take guilt-free vacations and enjoy more of life's pleasures. People may lament certain investments that don’t pan out but very few people regret paying off debt.
So what should you do?
Should you aim for the growth and the magic of compound interest by investing? Or, should you free up your cash flow and get a guaranteed return by paying off debt?
It depends.
If you get a great investment return (like a retirement match at your job) then investing likely makes the most sense. If you have high-interest debt from a credit card or personal loan, then paying down that debt likely makes the most sense.
If you’re in between or neither scenario applies to you: Let the interest rate be your guide and if all else fails, split the difference.
If the interest rate on your debt is higher than the estimated, inflation-adjusted returns you expect from your investments then it likely makes more sense to invest. How do you make this comparison? Take the estimated return you expect to get from your investment, subtract out inflation, and compare your new inflation-adjusted return on investment to paying down debt. If the estimated return you get on your investment is still greater than what you would get on your debt then invest. If the estimated return you get on your investment is less than the interest rate on your debt then pay down the debt. If the returns are about the same or you are unsure which one is better, then do both. Use a portion of your income to pay down debt and another portion to invest. How much you allot to each category largely depends on your risk tolerance, personal goals, and overall financial plan. 50/50 is a good place to start.