One of the toughest questions I get asked regularly is: “How does someone start investing when they have debt?” The reason this is tough is because so many people have unique financial situations. Making blanket statements about when to start investing is tough. However, over time, I've come to find a few truths regarding investing when you have debt, and I wanted to share them with you.
If you want to skip this article, remember this: the bottom line is that you can and should invest when you have debt. The important thing is to be smart about it, and here's how you can do that.
When to Invest When You Have Debt
As I said above, it's always a good idea to invest when you have debt. In fact, you can even set yourself up for future success by investing when you have debt.
Financial pundits typically break debt up into two types:
- “Good” debt — mortgage, student loans
- “Bad” debt — credit cards, personal loans
And with each of these types of debt comes two possible scenarios:
- You can make payments and afford your debt service.
- You can't afford to pay back your debt.
In the first scenario, you can make payments and afford your debt. If this is true, then you should invest like normal — leverage your work 401(k), max out an IRA, and begin to invest in a brokerage account. You should definitely make your debt payments, and invest whatever extra money you have.
If you fall into the second scenario, it gets a little trickier. You already can't afford your debt, so paying it back may not be an option. You should always try to work your debt, whether by negotiating it down, changing your payment terms, or earning more money to pay it back. But if none of these are viable, you're going to have to claim bankruptcy. In either case, you should still invest — with one caveat . . . .
How to Invest When You Have Debt You Can't Afford
If you can't afford to make your debt payments, you should still invest, but only for your retirement. If you have a job that offers a 401(k), max it out. Make sure that you have enough money to live off of, but focus more on your 401(k) than your debt (since you can't afford it anyway).
The same is true for an IRA. If you can afford to live and contribute some to an IRA, do it! If you're going to claim bankruptcy anyway, you should save for retirement instead of making debt payments you cannot afford.
Why a 401(k) and an IRA? In bankruptcy, these retirement accounts are protected. You could have $1 million in a 401(k), and still get your debt erased in bankruptcy. That's why it makes sense to continue to invest, even if you can't afford your debt.
Never Do This With Investments and Debt
Now that you know that your 401(k) is protected, the only thing you have to remember is to not touch it! Too many people use their retirement accounts to pay off debt, and this is absolutely incorrect. Never take money out of a 401(k) or IRA to pay off debt. Not only will you pay a penalty for withdraw, you'll also pay tax on the money you withdraw. Then, you're putting it toward debt that you can't afford. You basically lose-lose. You lose money for the future. You don't get a better situation with your debt. You even have to pay more taxes.
The bottom line is this: if you are in debt and can invest, do it. It doesn't matter how much debt you're in or if you can afford it. If you can invest, you always should.
Is there any situation you can think of when you wouldn't want to invest?