Some people will decide to pay off all their debts before ever investing money, while others will say itï¿½s better to carry livable debt and be able to grow your savings over time. There are pros and cons to either option, depending on your financial situation.
What to consider first
According to an October 2014 article in U.S. News Money by contributor Joanne Cleaver, paying off debt first means losing potential compound interest earned on any investments you would have made during that time. On the other hand, investing first means having to manage your debt and pay more in interest over time. And if youï¿½ve invested your money, you likely have fewer funds to make payments toward your debt.
Cleaver says that understanding your financial situation and what you can handle is the largest determinant. She suggests you find your tipping point for affordability by looking at the interest rates of your loans and calculating how much it will cost you on a monthly basis to maintain the debt. If the number doesnï¿½t fall within your affordability parameters, consider paying off the debt before doing any investing.
To do this, Paul Heising, a financial adviser with California-based investment firm Smarter Decisions, recommends ï¿½[organizing] consumer debt accounts according to their interest rates so you can see which are costing you the most,ï¿½ and to ï¿½pay back loans with the higher interest rates first, especially if those rates are over 10 percent annually.ï¿½
Advantages of doing both
Other experts recommend striking a balance of paying off your debt and investing, but only with certain, less-risky investments at first. Joshua Kennon, author of Investing for Beginners, suggested such a balance in a January 2016 article on the financial resource website TheBalance.com.
According to Kennon, you should fund any workplace retirement accounts, like a 401(k), and start an emergency fund using an FDIC-insured institution while paying down any high-interest rate loans, like student loans and credit cards. Then, he advises to circle back to investing more money into such savings vehicles as an IRA or Roth IRA, and begin building assets in mutual fund and brokerage accounts.
He listed three main points in his reasoning:
- ï¿½You minimize your tax bill, both from earned income and on investment income, which means more money in your own pocket.ï¿½
- ï¿½You create significant bankruptcy protection for your retirement assets. Your employer-sponsored retirement plan, such as 401(k), has unlimited bankruptcy protection under the current rules, while your Roth IRA has $1,245,475 in bankruptcy protection as of 2015.ï¿½
- Reducing debt over time allows you to build up while you pay down, so that when you are debt-free you suddenly have a major stream of cash to do with what you want.
An article by CFP Nick Holeman for investment management firm Betterment suggested a similar plan to pay off debt while investing in certain funds.
Holeman advised making at least the minimum payment on your bills, on time, while taking advantage of any employer retirement savings as you pay off major debt. Then you can build your emergency fund and finally invest further for retirement and savings.
Contributing to your company 401(k), even with debt, is important, said Holeman. Especially if your employer has a match contribution, making your contribution maximum to earn the match can yield a higher return on your investment than can many other investment alternatives.
ï¿½If you have debt thatï¿½s costing you over five percent in fees, pay it off as fast as you can. Start with the highest-interest debt first,ï¿½ Holeman suggested.
In the end, the decision between off all your debts first, investing all your money first or balancing a plan of both depends on your financial risk-taking and resources.