- Paying off your debt can help free up cash flow, avoid unnecessary interest charges, and alleviate emotional stress.
- Investing may provide the opportunity for long‑term asset growth, though returns are not guaranteed.
- Make your choice based on your financial priorities. If resources allow, consider a hybrid approach that allows you to reap the benefits of both.
Is it better to pay down debt or invest your money? It’s common to ask yourself which is a better use of any extra monthly income or a large windfall you’ve received.
While both options might be a great use of your capital, there may be some advantages to using one over the other in certain situations.
Here's what you need to know about paying down debt vs investing your money.
Understanding the Dilemma
Before you can choose a path for your finances, it may help you to understand the situation from both sides.
What Is Debt?
Debt is a financial obligation to pay someone back. Typically, we enter into debt when we wish to buy something with money that we don't currently have. Lenders are often willing to let us borrow the necessary funds as long as we agree to pay them back because there’s an opportunity for them to charge interest for the use of their capital.
It’s helpful to think of debt as one of three types:
- High-interest debt: Typically, when interest rates are over 10%. These may include financial products such as credit cards, unsecured personal loans, title loans, or payday loans.
- Medium-interest debt: Generally, when interest rates are between 5% and 10%. These types of loans may be used to finance things like vehicles, private student loans, or secured personal loans.
- Low-interest debt: When interest rates are 5% or less, and may even include some potential tax advantages. Examples include mortgages and federal student loans.
While it’s easy to say that you can (or should) avoid debt by paying for things with cash, this is not always practical or possible. For instance, many people don't have enough cash on hand to outright buy a home or pay for college. Hence, debt may make it possible to follow through on these purchases using a mortgage or student loan.
What Is Investing?
Investing is allowing someone to use your money with the expectation of getting it back plus some additional profit or income. Essentially, you're allowing another person or organization the temporary use of your capital with the understanding that it may grow in value with time.
There are many examples of investing:
- Earning interest on savings parked in a bank account.
- Buying a stock at a lower price and then selling it at a higher value.
- Contributing to a tax-advantaged retirement account like a 401(k) or IRA.
- Owning property, such as a rental unit, that produces monthly income.
- Holding an ownership stake in a revenue-generating business.
Often, investing begins with little more than participating in a workplace retirement account or buying securities on the stock exchange. However, investing does not always produce positive results. Typically, as you seek a larger return, the potential to lose some of your investment also increases.
Benefits of Paying Off Debt
Even though having debt has become fairly commonplace in our society, this doesn’t mean you have to let it run your life. Here are a few reasons why you may want to pay off your debts.
Emotional Relief and Stress Reduction
Paying down outstanding balances isn’t just good for your finances. It’s also important for your overall health and future well-being.
According to the National Institutes of Health (NIH), people with debt, especially heavy amounts, are more likely than others to suffer from stress, anxiety, and depression. When left untreated, this can eventually start to have physical effects such as fatigue and high blood pressure. It can also lead to further poor financial decisions, which may cause the situation to spiral even worse.[1]
Many people who eventually pay off their debts report feeling more in control and optimistic. Eliminating a balance completely may result in a euphoric feeling of accomplishment, like a weight has been lifted from your shoulders.
Improved Credit Score
Having less debt may also lead to a higher credit score. FICO, the most widely used type of credit score, is based on several factors — one of which focuses on how money you owe.
Also known as your "credit utilization ratio", this is the percentage of your accumulated balances relative to your total line of credit. For instance, if you have a credit card with a $10,000 limit and a balance of $2,500, then your credit utilization ratio is 25%.
Because amounts owed can affect up to 30% of your FICO Score, it’s important to keep it to a minimum. Many financial experts recommend keeping your credit utilization ratio to no more than 30%. This can be accomplished by using credit responsibly and paying off your revolving balances.[2]
Increased Cash Flow
When your debt gets paid down, it may free up your finances to do whatever you wish with them. This could mean having more funds to put toward a large-scale purchase like a new vehicle or home. It might also mean having additional resources to allocate to long-term goals such as retirement and investing.
If you haven't already, a good way to avoid future debt is to build an emergency fund. An emergency fund is a buffer of cash that you can use at any given time for a true emergency, such as an expensive auto repair, unplanned medical bill, or even job loss. Many financial experts recommend saving as much as 3 to 6 months' worth of living expenses to ensure you're fully covered for the majority of life's unexpected surprises.
Benefits of Investing
Investing may be a great way to eventually become financially independent. Here are a few of the many advantages of being an investor.
Long-Term Wealth Accumulation
People who have been investing for a long time typically notice that their balances grow significantly over time — often much more than the sum of their contributions. Why does this happen? Because of compound interest.
Compound interest is when money grows on top of the money you’ve saved, plus any accumulated earnings. Given enough time, your earnings may begin to grow at a faster rate than the money you're personally contributing.
This is how many people are able to eventually retire. Having saved for many years and allowing the compound interest from their investments to multiply the earnings, it eventually becomes enough money to sustain their lifestyles for the foreseeable future.
Potential for Higher Returns
While earning interest on your savings at the bank is good, investing may offer better opportunities for higher returns. For example, those who buy funds that mirror a broad-based stock market index make an average annualized return of 10%.[3]
Of course, as you pursue higher returns, you must also be prepared for the potential risks. Continuing with the example of the stock market, returns are never guaranteed and may lose value in some years. Sometimes this may even be due to external factors such as economic conditions or the latest media headlines. Therefore, it’s worthwhile to consider your tolerance for risk when assembling your portfolio.
Employer-Matching Contributions
With a 401(k) workplace retirement plan, many employers offer a specific investment perk called matching contributions. This is when they match the retirement contributions of their employees, sometimes dollar-for-dollar. Generally, the more someone utilizes their 401(k), the more contributions they'll receive from their employer (up to some preset limit).
Final Thoughts
While both investing and paying off debt may be a great use of your money, there may be some benefits to prioritizing one over the other. Perhaps the best approach is to weigh your options carefully and consider a strategy that contains elements of both. If you're uncertain, please feel free to consult with a financial professional for guidance.
