Investing or Paying Down Debt: Which Comes First?
Undoubtedly, you have heard of an exciting opportunity to grow your wealth by putting your money to work — it’s called investing. With investments, you purchase a financial product at a low price and sell that product at a higher price, thereby increasing your wealth. You can enact the same principle with works of art or real estate or anything that builds value over time, but investing in financial assets rather than physical ones tends to be more accessible and convenient.
Yet, what if you have debt? Investing isn’t prohibited to those who are saddled with debt, but there are certain instances where it might be wise to pay down debt before departing on an investing journey. Here are a few good rules of thumb to employ when considering investing while under debt:
Pay Credit Card Debt First
Almost regardless of your financial goals and plans, you always need to pay off credit card debt as soon as possible. Credit cards tend to come with punishingly high interest rates, which means credit debt can get out of control with outstanding speed. Worse, because minimum payments are so low, if you are only contributing the minimum every month, you could be creating a long-term paycheck-to-paycheck lifestyle that will never permit investing and building wealth.
Fortunately, paying down credit debt is doable, as long as you have a plan. You will need to adjust your budget and tighten your belt, but once your debt is eliminated, you will have more financial freedom. Here’s financial guru Dave Ramsey’s step-by-step guide for cutting down credit card debt:
Step 1: List your credit debts from smallest to largest, and begin paying only minimum payments on all but the smallest balance.
Step 2: Pay down the smallest balance rapidly using as much money as you can squeeze from your budget. Once that balance is eliminated, apply your largest payment to the second-smallest balance.
Step 3: Continue eliminating debts in this manner, transferring your large payment to the smallest extant balance. Close credit card accounts as you pay off their balances.
Other financial gurus advocate for paying down your accounts with the highest interest rate first — and ultimately, you should choose the method that makes sense to you. However, once you are debt-free, you can shift some or all of the money you devoted to paying your credit debt to investment.
Invest Outside of Mortgage First
If your only debt is a mortgage, you might benefit by maintaining your house loan and launching into other investments. Mortgages are often considered “good debt;” they themselves are investments that will contribute to your wealth.
Some financial gurus advise aggressively paying down mortgages before looking for other investment opportunities, but considering the size of most mortgages and the relatively low interest rates associated with them, they are typically not an obstacle to investment. Notably, this is also true for most other forms of debt, like student or auto loans. What’s more, because you have already benefited from student loans and because auto loans do not provide a favorable return, there shouldn’t be much rush to pay these off.
Instead, you can begin focusing on accruing the money you will use for investments. The best way to do this is to pay yourself first — to transfer money directly from your paycheck to your investment account. Many investment tools allow you to set up direct deposit, which can be helpful in boosting your principal over time. Speaking of tools, you should also start using an investment tracker as soon as possible, so you can start paying attention to the funds and stocks you hope to buy into.
Conclusion
The decision to pay debt or invest is a difficult and personal one. In truth, the best advice is to compare the debt’s annual percentage rate with your prospective portfolio’s expected return. If you project that your investment will make more money than you would spend paying down your debt, then investing might be worthwhile. Conversely, if your debt will out-grow your investments, you need to eliminate that drag before you can start building wealth.
The road to wealth is paved with tough decisions, and this is merely your first. You need to consider your circumstances, goals and resources to make the best financial decision for you and your future.
