Being in debt feels kind of icky, doesn’t it? It itches in the back of your mind, constantly reminding you that you’re on the hook.
You probably dream of the day when you can make that last payment on your mortgage, your car loan, your student loans, or your credit cards, but should you really be putting all your extra income into paying down debt instead of investing in your future? Does it ever make sense to invest when you’re in debt?
What Makes You Feel More Secure?
If your debt is a constant thorn in your side, then maybe investing isn’t right for you until you’ve paid off every last penny that you owe. At the end of the day, paying off debt is a solid investment plan in its own right.
The more debt you pay off, the less interest you’ll have to pay, which means financial gains for you. However, it is worth considering whether you should begin investing some of your money while you are also paying off your debt. In some cases it might actually make more financial sense.
Can You Make More Investing Than Paying Down Debt?
To decide whether investing is a good idea for you, we must first acknowledge that not all debt is the same. As of the writing of this article, interest rates are at historic lows.
It may be possible to get a car loan with a 3% interest rate or a mortgage with a 4% interest rate. Contrast that with the stock market. The stock market is a rollercoaster, up some years and down in others, but stocks, over long periods of time, have gained an average 7% a year, which means you could potentially make more money investing some of your extra funds than paying off low interest debt.
(You may be able to earn even more on your investment when you avoid these five common investment mistakes.)
Major Caveat One: Pay Off Your Minimums First
The question of investing your money becomes moot if you are struggling to make your minimum payments on your loans each month. If you fail to make those payments, the additional penalties you will incur, as well as the damage to your credit score will likely outweigh the benefits of what you can earn through investing.
Major Caveat Two: Tackle High-Interest Debt
It doesn’t make sense to earn an average 7% interest on an index fund investment if you’ve got a huge amount of debt on a credit card charging you 21% interest each month.
If you’ve got high-interest debt, it’s always smarter to pay that off first before your lower interest debt or before you begin putting away a lot of extra money into investments.
Of course, it’s an even better idea to try to lower that interest rate while you work to pay off that debt. This can be done with a balance transfer to a lower-interest credit card or by taking advantage of the many available transfer balance deals that often include an interest-free period. (You should also check out our article on how to get off the credit card rollercoaster.)
Major Caveat Three: Start Investing with a Retirement Plan
Your first investment should always be your retirement plan, and this is the one investment you should consider making even if you would prefer to pay off your debt before investing.
Even if you can only put a small amount of money into your IRA or 401(k), the earlier you begin saving, the more powerfully the fund will work for you through compound earnings.
If your work matches a percentage of your retirement savings, then you definitely need to take advantage. That’s free money you’d be giving up. At least save up to the amount your employer matches. You’ll be doubling your money, which is a better deal than paying off even your highest interest loans and credit cards. (Is it time for a retirement progress check-up?)
The Final Caveat: Go For Low-Fee Investments
If you do decide to start investing some of your extra funds instead of paying off your debt, make sure you’re coming out financially ahead. One of the easiest ways to shoot yourself in the foot (financially speaking) is to spend your money paying fees to brokers and mutual fund managers instead of investing in your portfolio.
This is not the time to start actively trading (since every trade has a fee) or to go in on a heavily managed fund (which will include high maintenance and management fees). Instead, stick with a low-fee or no-fee index mutual fund that tracks a major stock index. These are no-worry funds that usually outperform the vast majority of managed mutual funds!