Investing v. Paying Off Debts

If you’re like most 20-something Americans, odds are that you’re in debt. Student loans, car payments, and credit card debt can add up incredibly quickly, taking a bite out of every paycheck you receive. For many Americans this debt can seem unmanageable; in fact, a study by the American Psychological Association shows that money trouble is one of the leading stressors of American youths. With this in mind, it may seem that the logical course of action is to pay off all debts as soon as possible. In this economic climate, however, with low mortgage rates and sky-high credit card interest, it’s often more complicated than that. Sometimes, the more prudent decision is to hold onto your debts and invest the borrowed money.

It should be noted, before discussing whether to invest or pay off debts, that in some circumstances you should do neither. The first priority for most Americans should be establishing an emergency fund: enough money to pay for 3-6 months of expenses in the event of income loss. It should also be noted that making the decision to invest your money instead of paying off debts assumes that you will continue to make your regular payments toward the debt. The profit from investing borrowed money disappears very quickly once you start adding late payments and interest accrual. So, you’re a young adult with debt and disposable income. Should you invest the extra income, or pay off your debts?

The short answer is that it depends.

The long answer is that both interest rates and available investment vehicles must be taken into account when making this decision. For instance, if you’re deciding between paying extra toward a mortgage with 3% interest, or investing in the market where you could receive a conservative 7% return, you should invest. Ignoring taxes, the borrowed money will be earning a return above what you need to pay back, netting you a 4% return. Conversely, if you’re paying 12% interest on a credit card loan and can only make 8% in the market, you should pay off the credit card before investing. However, what if the investment vehicle you would use is a 401(k) or a Roth IRA? On a relatively small loan, employer matching on 401(k) contributions could make the monetary benefit of investing much greater, even if the interest rate is lower than the debt rate. It may also reduce your taxable income for the year, saving money on taxes. Similarly, investing in a Roth when you’re in a lower income tax bracket may be more profitable in the long run than paying off a relatively stable debt with a higher interest rate.

Luckily, the disparity between consumer and non-consumer debt interest rates tends to make this decision easier. In 2015, the average 30-year mortgage rate was 3.85%, while the average credit card interest rate was an exorbitant 12.09%. With a conservative 7% return in the market, the choice is clear: pay off consumer debts, and invest with your non-consumer borrowings. Often, that rule of thumb is enough.

Of course, this is only from a mathematical perspective. In reality, most Americans should prioritize saving at all points in their life; otherwise, people will always find reasons not to save. Even with a high-interest debt and a limited cash flow, it is usually best to put most of the money toward the debt while still contributing the rest toward your savings. The percentage that goes toward debt or savings should change based on how serious the debt is, but the best habit is to always save first.