How to Decide Whether to Invest Or Pay Off Debt for Your Ideal Future

 

The Big Financial Dilemma: Invest or Pay Down Debt?

At some point in your financial journey, you may find yourself with extra money and face a crucial decision: Should you use it to pay off debt or invest for the future? Both choices have benefits and potential drawbacks and the right answer depends on your unique financial situation.

On one hand, paying off debt offers a guaranteed return by reducing the amount of interest you’ll pay over time. On the other, investing gives you the opportunity to grow your wealth, potentially outpacing the cost of debt with strong market returns.

So how do you decide? The key is to analyze your financial position, understand how interest rates affect your money and determine the best course of action based on your long-term goals.

Understanding the True Cost of Debt

Debt isn’t just about what you owe—it’s about how much it’s costing you over time. When you borrow money, whether through a credit card, student loan or mortgage, lenders charge interest, which is the price you pay for using their funds.

 

High-Interest vs. Low-Interest Debt

Exactly what is considered high-interest debt can vary from person to person and many agree it depends on how old you are. For example, 5% in your 20s may still be considered low, while 5% in your 60s may be considered high. It’s also important to note that while Ideal Credit Union offers consistently low rates, those rates depend on the economy as a whole. This may make the lowest rate loan available over 6% from any lender.

That said, here is one way to determine high-interest from low-interest, without taking it as a perfect guideline for every person in any economic circumstances:

• High-Interest Debt (6% or more): This includes credit card balances, payday loans and some personal loans. These types of debt can quickly snowball due to compounding interest, making them costly to carry.
• Low-Interest Debt (under 6%): Mortgages, student loans and some auto loans often fall into this category. These debts may be more manageable, especially if they come with tax advantages or fixed repayment terms.

To illustrate this with a practical example: if you have credit card debt at 18% interest, paying it off is almost always the smarter choice. That’s because investing in the stock market, which historically returns around 7-10% annually, is unlikely to outpace such a high interest rate.

However, if you have a mortgage at 3.5% interest, investing could be the better option since your potential investment returns could outweigh the cost of your debt.

 

The Power of Investing: How Compounding Works

Investing is one of the most powerful ways to build wealth over time, thanks to compounding interest—the process where your earnings generate even more earnings. The longer your money stays invested, the more exponential growth you can experience.

 

Example of Savings Growth

Let’s say you invest $5,000 per year into a retirement account with an average annual return of 8%. Here’s how your money would grow over time:

• 10 years → $75,000
• 20 years → $237,000
• 30 years → $586,000

This happens because your investments generate returns and then those returns reinvest and grow year after year.

This is why starting early is so important—the longer you let compounding work in your favor, the less you need to contribute to reach your financial goals.

 

Key Factors to Consider Before Making a Decision

Now that you understand both the cost of debt and the potential of investing, here are some critical factors to weigh before deciding where to put your money:

1. Interest Rates on Your Debt
   • If your debt has an interest rate higher than 6%, prioritize paying it off.
   • If it’s lower than 6%, investing may be a better choice, especially if you have a long time horizon.
2. Your Emergency Fund
   • Before tackling debt or investing, ensure you have 3-6 months’ worth of expenses saved in an accessible emergency fund.
3. Employer Match on Retirement Accounts
   • If your employer offers a 401(k) match, contribute at least enough to get the full match—it’s essentially free money.
4. Your Risk Tolerance
   • Paying off debt is a guaranteed return, while investing carries risk. If market fluctuations make you uneasy, paying off debt may provide more peace of mind.
5. Your Long-Term Financial Goals
   • Are you planning to buy a home, start a business or retire early? Your goals should shape your decision.
6. Tax Considerations
   • Some debt, like mortgage interest and student loans, may offer tax deductions, making it less urgent to pay off compared to non-deductible high-interest debt.

 

When Paying Off Debt Should Be Your Priority

Paying off debt should be your first priority if it is high-interest debt, negatively impacts your financial security (which all debt does, to one degree or another) or limits your ability to save for the future. Here are key scenarios where prioritizing debt repayment makes the most sense:

 

1. You Have High-Interest Debt (6% or More)

• Credit cards, personal loans and payday loans often have double-digit interest rates, making them expensive to carry any longer than necessary.
• The average credit card interest rate is around 20-25%, which can quickly make a small balance spiral out of control.
• No investment can guarantee returns that consistently beat these interest rates—paying off this debt is a guaranteed return on your money.

 

2. Your Debt Is Causing Financial Stress

• If debt payments are straining your monthly budget or making it difficult to cover essential expenses, eliminating them should take priority.
• Living paycheck to paycheck due to debt payments can increase financial insecurity and limit future financial opportunities.

 

3. You’re Struggling with Credit Score Issues

• Carrying large balances relative to your credit limit negatively impacts your credit utilization ratio, a key factor in determining your credit score.
• Lowering or eliminating debt can improve your credit score, making it easier (and cheaper) to borrow for things like a mortgage or auto loan in the future.

 

4. You’re Nearing Retirement and Need Financial Stability

• If you’re close to retirement, eliminating debt ensures that you enter your later years without burdensome monthly payments.
• Without steady income from a job, high-interest debt can eat into retirement savings quickly.

Bottom Line: If your debt has high interest rates, is stressing your finances or hurting your credit score, focus on paying it off first before considering investments.

 

When Investing Might Be the Better Choice

In some cases, investing your extra funds instead of paying off low-interest debt can be the smarter financial decision. Here’s when investing may make more sense:

 

1. Your Debt Interest Rate Is Low (Below 6%)

• If your mortgage, student loans or auto loans have interest rates lower than what you’d earn by investing, it makes sense to invest instead.
• Historically, the stock market averages 7-10% annual returns over the long term, meaning investing often outpaces low-interest debt costs.

 

2. You Have an Employer Retirement Match

• Some employers offer 401(k) matching contributions, contributing essentially free money for your retirement.
• If you’re not contributing at least enough to get the full employer match, you’re leaving money on the table.

 

3. You Have a Long Investment Time Horizon

• If you have 10+ years before you need the money, investing allows you to take advantage of compounding growth.
• The longer your money stays in the market, the more time it has to push through short-term fluctuations and grow.

 

4. You’ve Already Built an Emergency Fund

• Before investing, ensure you have at least 3-6 months of living expenses saved in a high-yield savings account.
• Without an emergency fund, you might have to rely on credit cards for unexpected expenses, negating the benefits of investing.

 

5. You Can Handle Market Volatility

• Investing comes with risks and ups and downs. If you’re comfortable seeing market fluctuations and staying invested long-term, investing might be the right move for you.

Bottom Line: If your debt is low-interest, you have an emergency fund and you’re taking advantage of employer retirement benefits, investing can be the better choice for growing wealth.

 

Balancing Both: A Hybrid Approach to Financial Growth

For many, the best strategy isn’t an either/or decision—it’s a balanced approach that allows you to pay down debt while still investing for the future. Here’s how you can do both:

 

1. Prioritize High-Interest Debt First

• Any debt above 6% interest (like credit cards) should be paid off aggressively while making minimum payments on lower-interest debts.

 

2. Contribute Enough to Get Employer 401(k) Match

• If your employer offers a match, contribute at least the minimum needed to get the full match before putting extra toward debt payments.

 

3. Use the 50/30/20 Rule

A popular budgeting method is:

• 50% of income for necessities (rent, food, utilities).
• 30% for discretionary spending (wants and lifestyle expenses).
• 20% for financial goals (debt repayment + investing).

You can split that 20% between paying down debt and investing based on your personal priorities.

 

4. Consider a Debt Snowball or Avalanche Approach

• Debt Snowball: Pay off the smallest debts first to gain momentum.
• Debt Avalanche: Pay off highest interest rate debts first to save the most on interest.

 

5. Automate Both Payments & Investments

• Set up automatic debt payments to ensure you never miss a due date.
• Use automatic investments to contribute to retirement or brokerage accounts each month.

Bottom Line: If you want to build wealth while getting out of debt, create a plan that allows you to pay off high-interest debt first while consistently investing for your future.

 

Building a Financial Plan for Long-Term Success

Regardless of whether you prioritize debt repayment or investing, the most important step is having a clear financial plan that aligns with your long-term goals. A solid plan helps you stay on track, manage risks and make informed decisions at each stage of life.

Start by taking a comprehensive look at your financial situation—list all debts, their interest rates and monthly payments, along with your investment accounts and income sources. From there, establish clear priorities based on your short-term and long-term objectives.

For many people, a balanced approach works best. This means simultaneously reducing debt while investing for the future. For instance, allocating a portion of extra income to both investing and debt repayment can provide financial flexibility without sacrificing future growth.

Automating payments and investments is another key strategy. Setting up automatic debt payments ensures you stay on track, while automated investment contributions help build long-term wealth effortlessly. This approach reduces the temptation to overspend and ensures financial discipline.

 

Final Thoughts: Making the Best Choice for Your Ideal Future

At the heart of the investing vs. paying off debt debate is one key question: Which option will put you in the strongest financial position? The answer depends on factors like interest rates, investment returns, tax benefits and your personal financial goals.

Ultimately, the most important thing is to take action—whether it’s reducing debt, investing for growth or a combination of both, being proactive will lead to greater financial freedom and long-term security.

Have questions? Give us a call to discuss our savings options, talk about paying off credit cards and more!