A topic that consistently comes up on social media from readers is whether they should pay off debt before investing in real estate, retirement, or stocks. While there are numerous pundits out there voicing very different views on the matter, we wanted to highlight both sides of the argument.
Why You Should NOT Pay Off Debt Before Investing
The very first thing you have to determine before answering this question is what type of debt are you faced with. If you are in the hole $50,000 in student loan debt, but have zero consumer (credit card, auto) debt, then you could potentially be a much stronger candidate to start investing. Contrary, if you are racking up new debt monthly thanks to a car note or an Amex bill, you need to focus on building an emergency fund, and using a debt strategy such as the debt snowball method to get out of debt.
Even if you did have consumer debt, it still could make sense to begin investing before paying off debt. For this example, you have purchased a certified pre-owned Honda Accord, and after all taxes, fees, warranties, etc, your loan amount will be $20,000. You will pay your local credit union 5% over the course of 5 years (60 months), which equates to $2,645.48 in interest should you keep the loan the entire term.
Related: The Debt Avalanche Method Explained
If you had $20,000 saved up in your emergency fund, you could invest that in a pretty basic diversified investment portfolio, with expectations to yield returns between 6-10% long term. For this example, we will split that range down the middle, and in the same five year period, you average 8% on your investment.
Since you know your investment will yield a greater return on your principal than if you paid off the car loan, it makes sense (assuming other factors here such as you have no other debt, have income to make the car payment aside from the emergency fund, etc), to invest now, and make the auto loan payments.
Why You SHOULD Pay Off Debt Before Investing
Taking the same example above, if you had debts whose interest rates are higher than the expected five year return, those need to be paid immediately. Credit cards fall in this category, as while cards are not trouble, carrying credit card debt from month-to-month is. Do not fool yourself and get in the balance transfer carousel, moving purchases you made from 3 years ago to a new credit card yet to be opened, without putting a serious dent into the principal. It will catch up to you.
Student loan debt could also be a candidate for repayment in this example. Many privately issued student loans come with rates that once in repayment could eclipse the return you expect to see from your portfolio. If that is the case, you are better suited to eliminate the debt. Other situations where you should pay off debt before investing includes paying down delinquent taxes, paying off debt owed to family, or medical bills.
If your only debt is tied to real estate in the way of a mortgage, we recommend moving forward and starting to invest. Your monthly, quarterly, and annual personal budget should anticipate the monthly payments for your house, and build in hypothetical returns you expect from your portfolio.
If you want to play around with numbers via an online investment portfolio calculator, check out Moneychimp.com’s right here.