Should you pay off debt or invest?

You're doing well financially and have extra money each month. Now, a crucial question arises—should you pay off debt or invest the surplus?

It's a common dilemma facing many households. On one hand, eliminating debt provides guaranteed "returns" by slashing interest charges. On the other hand, investing offers potentially higher gains but involves market risk.

So what's the better move: be debt-free faster or grow your money in the stock market? It depends on your goals.

Paying down debt first

Paying off loans before investing has advantages. Here's the case for focusing on debt elimination.

Pay less in interest

Carrying debt costs money every month in interest charges. Payday loans or credit cards can have annual percentage rates (APRs) of 30% or higher.

Paying these off as soon as possible saves all the interest you'd otherwise pay over the loan's duration. That's like getting a guaranteed 30% "return" on your money.

Even mortgages and student loans with interest rates around 7-9% really add up over time. Accelerating payments to wipe out debt faster maximizes interest savings.

Reduce financial risk

Debt comes with obligatory monthly bills. If you lose your income, those payments are still due, and if you can’t pay you run the risk of late fees, defaults, and damage to your credit.

By eliminating debt, you reduce your fixed living expenses and can begin to build cash reserves. This lowers your risk of falling behind on payments if you face unemployment or emergency costs down the road.

Improve your cash flow

Freed-up cash flow each month is another benefit of becoming debt-free sooner.

Imagine having an extra $500 or more to save and invest after eliminating car loans and credit card balances. That cash buffer can give you more financial wiggle room for spending and investing.

Build better credit

When evaluating you as a borrower, lenders consider your outstanding debt and credit utilization. Paying off installment loans and credit cards can sometimes boost your credit score by over 100 points.

Higher scores mean you will qualify for lower interest rates—and therefore substantial savings—on financing for cars, mortgages, and other types of loans.

Retire earlier and gain peace of mind

With debt gone, your money toward monthly payments can flow into retirement accounts instead. This allows you to reach your retirement savings goals years faster.

Finally, becoming debt-free provides intangible benefits like reduced stress and anxiety. The mental burden and worry about owing money (and paying all that interest) evaporates when you make that final payment.

Investing over paying off debt

On the other side of discussion, there are also good arguments for prioritizing investing over prepaying debt

Higher investment returns

Historically, stock market returns exceed the interest rates on most types of consumer debt. Although, as you’ve heard many times, past performance doesn't guarantee future results, investing early optimizes growth potential.

For example, the S&P 500's average annual return over the past 30 years is around 10%. That beats the interest charged for car, student, and home loans. But not on credit cards.

Tax-deferred growth

Investment accounts like 401(k)s and IRAs offer tax-deferred growth. Money compounds without being taxed until withdrawn in retirement. This turbocharges portfolio growth compared to taxable investments.

Prepaying debt doesn't provide this tax advantage. Accelerating student loan or mortgage payments lowers interest owed but lacks tax-deferred growth.

Manageable debt can help

With responsible use, some debt is okay. Mortgages enable homeownership. Student loans make college affordable.

With their lower fixed rates, these kinds of debts are reasonable to carry if you are investing and saving at the same time. Prepaying them may not be the optimal use of money. As always, do the math.

Avoid market timing

Historical data shows the benefits of investing consistently for decades. Trying to time markets often backfires.

Skipping early years in investing to pay off low-rate debt forfeits potential compound growth during prime earning years. Time in the Market typically wins over timing dips and peaks.

Prioritize retirement accounts

Many experts suggest prioritizing tax-advantaged retirement accounts before tackling debt. Earnings grow tax-free, and contributions may be tax deductible or pre-tax.

Utilize 401(k) match offers, then max out IRAs and other accounts before putting extra cash toward debt repayment. This staged approach balances saving and debt repayment.

Key factors to consider

Now that you understand both perspectives, how do you decide what's the smartest long-term strategy for you? Here are key factors to weigh:

• Interest rates on debt — The higher the rates, the greater the benefit of paying off those balances first. Prioritize high-rate debt before low-rate debt.
• Time horizons — If retirement or other goals are decades away, time in the Market outweighs debt interest. But if goals are nearer term, eliminating debt may take priority.
• Risk tolerance — Paying off debt guarantees fixed returns by saving interest. Investing offers potentially higher gains but with market volatility. Determine your comfort level.
• Employer match — Not contributing enough to get the full 401(k) match leaves free money on the table. At a minimum, invest enough to maximize that free match.
• Tax implications — Savings from prepaying deductible debt like mortgages and student loans are less than savings from non-deductible debt like credit cards and auto loans. So, consider the after-tax impact.

The balanced approach

While there is no one-size-fits-all answer, taking a balanced approach is often the wisest path.

In most cases, the optimal strategy is to both invest and pay down debt at the same time—just be sure to allocate your available money judiciously between the two financial goals.

For example, this strategy hits both objectives effectively:

• Contribute enough to 401(k) to get full employer match
• Build an emergency fund
• Pay off all high-interest credit card and loan debt
• Max out IRA contributions
• Accelerate payments on moderate-interest debt like mortgages and student loans
• Increase 401(k) contributions toward max
• Open a taxable investing account once you’ve maxed out tax-advantaged options

This flows savings to their optimal uses. You avoid missing out on free retirement match money

while also eliminating costly credit card debt. It's about prioritizing the right accounts before accelerating debt payoff.

Take time to evaluate your specific debt, investment options, time horizons, and risk tolerance. Then, develop an optimized game plan to pay off debt faster while growing your money in the stock market.

With the right balanced strategy, you can work toward achieving your financial goals while also systematically paying off your debt.