When you have many financial goals for your available income, you may need to choose where to focus those funds. You might debate between paying down any debt as soon as possible or using that money to invest.
Debt repayment is often prioritized, but that isn't the only approach. You also can use debt strategically depending on how it fits within your broader financial plan. Let's explore considerations to help you decide if it's better to pay off debt, invest or do both at the same time.
Not all debt is bad
Some debts may be weighing you down, while some may be helping you get ahead. When thinking about
High-interest vs. low-interest debt
High interest rates drive up the cost of borrowing and make holding on to debt more expensive.
- Credit cards are a good example of high-interest debt. They often charge 20% interest or higher. So, for every $1,000 you owe, you could lose $200 or more per year to interest charges if balances are not paid off monthly.
- Personal loans often charge higher interest rates, too. Rates can vary depending on your credit score and the loan terms but could easily be above 10%.
Debts with lower interest rates are more manageable because the cost of carrying a balance isn't as high.
- Mortgages can have low interest rates. Although the rate on newly issued mortgages has gone up recently, many people have mortgages with 2% to 3% rates.
- If you have a good credit score, secured personal loans also can have a low interest rate.
It's not a coincidence that "good" debt and low-interest debt are often the same, as are your "bad" and high-interest debts. It's easier to make a case for paying down high-interest, "bad" debt as quickly as possible, but you may be able to leverage low-interest debt if you could earn more on the same money if it were invested.
What purpose does the debt serve?
You also can think about why you have the debt in the first place. Some debts help you achieve your goals, while others slow your progress or even may prevent you from achieving them entirely.
An example of "good" debt that might help you is a student loan. Student loans can allow you to earn a credential that qualifies you for a better-paying job, or one with a more flexible schedule so you can spend more time with your kids.
On the other hand, consumer debt you accumulate for no real purpose doesn't help you get ahead.
Should you pay off low-interest debt?
Making extra payments on your low-interest debt can come with an opportunity cost, and you may need to calculate which option works best for you. These additional payments can help you get ahead and avoid paying some interest. But the tradeoff is you may miss out on earnings you could gain from investing that money instead. It all comes down to the greater incentive and how it fits into your larger financial strategy.
Say you have a student loan with a 5% interest rate. You're debating whether to pay down this low-interest debt or dedicate your money elsewhere. To help frame this decision, here are three ways you might use your money and how each compares to paying down your loan.
1. Put money in a savings account
When you put your money in a savings account, you could earn interest on those savings. But depending on the interest rate on your debt and your savings account, you could break about even. However, you'd still have access to your money in the savings account if you needed it.
If you're considering a traditional savings account, that interest rate may be around 1%. In this scenario, you might choose paying down a 5% student loan since the savings account would earn less than what you'd pay on the loan. If you're considering a high-yield savings account with higher interest rates of around 4-5%, it may be more appealing to save the dollars to keep them liquid, especially if you're building your
2. Open a certificate of deposit
You may earn more with a CD than with a traditional savings account, possibly up to 5%, but you may earn less than you'd pay on your student loan. This choice balances liquidity with the desire to maximize your interest.
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3. Invest in a mutual fund
If you invest in
Can you pay off debt & invest?
Yes, you could do both. Decide on your split by comparing your budget with your debt and investing priorities.
For example, suppose you have $300 per month to spend and one small debt you want to pay down. You may decide to put an extra $100 toward the debt and invest $200. Or if the balance is larger, you might decide to put $200 toward the debt to pay it down more quickly and invest the other $100.
How much is your debt costing you?
Consider your values & priorities
These calculations are just one side of the coin. Your
For example, your debt, even if it's the "good" kind, may cause more financial anxiety than you're comfortable with. Or you may prefer to prioritize a specific debt payment, like paying off a car loan so you can gift it to your kids or to someone who needs help. Paying down that debt could be more worthwhile to you than capitalizing on a higher interest rate in a savings account.
On the other hand, you may have a particular savings target in mind that would let you change jobs, buy a house closer to work, or feel more confident in your retirement plan. If achieving these goals lets you lead a more fulfilling life, you might pursue them instead of paying down your low-interest debt.
Your decision should lie in your goals and how your choice directly affects your ability to achieve them. Talk through all the possibilities with a