The shame of debt often meets the excitement of investing, leaving you with a tough decision to make. Should I pay off debt or invest?” The short answer is you should be tackling both. But in terms of priorities, one certainly comes in higher priority when considering a few important facts.
This article is intended for people who have any amount of debt, but aren't facing bankruptcy issues, foreclosure issues, or major tax payment issues. It also assumes that you have at least a small emergency fund of at least $500 to a few thousand bucks, depending on your financial situation.
When those are the case, you almost have no choice but to pay off your debt first (at least until you're caught up on all your debt), or start contributing to an emergency fund, or both before investing.
If you find yourself without debt problems like the ones mentioned above, but you haven't yet established a small emergency fund, then you would be smart to address this first, or at least give it a higher priority for the short term over investing.
All other scenarios allow me to explain why you should first invest your money, then tackle your debt problems after.
First Invest, Then Take Care of Debt
To be frank, you can look at this problem a hundred different ways. The way I tackle it is by listing financial objectives first, and then tackle the highest priority first.
Many financial experts may tell you to either pay off your highest interest debt before investing and others will tell you to pay off all your debt (with exception to your house) first. I think both of these options are great and have proven to work. But there is just one small problem…
It doesn't tackle a major behavioral habit that needs to be addressed when it comes to money, and I think this behavioral change is more important than ANY other money habit out there…
Why You Should Invest Your Money First
There are two big reasons that investing your money should come before paying off your debt.
It's human nature to want to spend money once you get it. We're creatures of habit, and since spending is the easier and often times more fun habit to follow, it becomes ingrained in us from the day we get our first paycheck or allowance.
This is, however, totally contrary to how you build wealth. In order to become wealthy, you need to keep a portion of every dollar you earn. Furthermore, you also need to invest that portion you save so that it grows and works for you.
First you save some money which makes you wealthier, then you invest that money which makes you even more wealthy. It's a compounding wealth building effect!
(by the way, take a look at the book called “The Compound Effect” by Daren Hardy to learn more about the magic of compounding)
Whether it's just $5 per week or $500 per week, the idea is to begin investing something every week on autopilot. If you're deep in debt and have a tight budget, I promise you that finding $5 per week can be done regardless of your scenario. Again, the idea is to ingrain the habit of paying yourself first and investing it automatically, not to be touched for years to come!
Using popular apps like Robinhood, Acorns, Stash or M1 Finance, you can invest any dollar amount in the stock market automatically.
If you look at the task of achieving the objective of saving for retirement, you'll notice it's probably a million times bigger (literally) than the amount of debt you have (for most people). Let me show you how to calculate this.
First, let's figure out how much you need to retire. To calculate the accurate amount, we need to know your desired retirement income, the expected inflation rate each year, and how many years until you retire. We'll say you want to live on $75,000 per year, you expect a 2.5% annual inflation rate and you have 30 years until retirement.
Next, head over to Calculator.net and click on “Financial Calculator” then type in the following under the FV (Future Value) tab:
- N (# of periods): Type in the number of years until you retire. For this example, we'll type in 30 years.
- Start Principle: Type in the desired income you want in retirement. For this example, we'll say $75,000.
- I/Y: Type in the inflation rate. For this example, we'll use 2.5%.
- PMT: This isn't necessary for this calculation, so type 0.
The result is your what your annual income will need to be when you retire to equal your desired salary in today's dollars. For example, $75,000 income today will be equivalent to $157,317.57. in 30 years after 3% annual inflation. (see screenshot below)
Lastly, take that final number and multiply it by 25 to determine the total savings you will need to retire on your desired income. For our example, the total retirement savings needed is $157,317.57 x 25 = $3,932,939.25 needed in order to retire.
Now, which number is bigger, your debt or your retirement savings goal?
This is why investing your money FIRST should be your top priority financially.
Now, this isn't to say that you should quit paying down your debt totally in order to invest, but it's saying you should START investing first, while continuing to pay down your debt.
Why Paying Off Debt Should Come Second
The initial habit that got you into debt in the first place was because you DIDN'T save more money, and/or you spent more than you brought in. This is, in fact, the exact opposite of what needs to be done to build wealth.
Why should paying off debt come second? Not only is it most likely much smaller than the amount of money you need to save for retirement, but it's also a financial aspect that you can still manage while you're saving and investing.
In fact, many people retire and still have debt payments they are making (which, isn't advisable, just to be clear). But their retirement savings provides them a large enough income that they can afford to make payments on their debt and continue paying it off.
Again, it all comes down to priorities, and saving for retirement is a much larger priority in my mind than is paying off debt. Not to mention the fact that we'll still be chipping away at the debt while investing anyways.
Once you've set up your automatic weekly investing amount (even if it's just $5 to start until your budget loosens up), the next habit to change is to stop using debt all together.
If you're not going further into debt, and you're saving a little and investing it in the stock market, you are making major leaps forward financially that will start gaining some major traction as you stay consistent.
A 4 Step Process to Invest & Pay Off Debt
Taking the points we've discussed thus far, I've created an easy four step process to invest your money in the stock market while tackling your debt as well. It goes as follows:
1. Invest What You Can
It doesn't matter how tight your budget is or how much debt you have, you should pay yourself first by investing AT LEAST $5 per week or more, with intentions of dramatically increasing that amount as your finances improve.
If this means saving your spare change, selling something on Amazon or eBay, working an extra hour or two or doing some extra freelancing work on the side, I promise you can find an extra $5 – $50+ to invest each week. You know your budget, so you be the judge on how much you can afford.
2. Stop Going Into Debt
Next, we need to “fix the leak” by eliminating bad spending habits. This means you need to commit to not going into debt anymore.
The best way to do this is by literally cutting up your credit cards never to use them again in the near future while you improve your financial health.
3. Pay Off Bad Debt
Once you've set up your investments on autopilot, committed to not using debt and not overspending, now comes the logical side of tackling your debt.
Whether this means using Dave Ramsey's famous “Debt Snowball” or whether it means paying off the highest interest debt first, this step focuses on staying on top of your payments and slowly chip away at your debt.
Personally, I prefer to pay off high interest debt first. Why? Because paying off a 24% interest rate credit card is equivalent to getting an immediate 24% return on your money that would have otherwise been spent on that high interest rate.
4. Invest More When You Can
Last but not least, as your debt becomes more manageable, you can begin increasing your weekly investment amounts. An easy rule of thumb here to determine whether to increase your investments or pay more towards debt is to use the 10% rule.
If your debt interest rate is higher than 10%, keep paying money towards debt. If your debt interest rate is lower than 10%, you'll likely get a higher return when investing for the long term by putting extra money in the stock market.