The other day I posted about When to Open a Roth IRA, and I got an interesting comment from Jason at Work, Save, Live. He wanted to start investing in a Roth IRA for many of the reasons I mentioned in the article, but he hadn’t started yet because he’s working his way out of debt.
My reply was that I think you can balance investing with paying down debt. However, the more I thought about it, the more I realized that my response doesn’t really apply in all situations. Here are some thoughts on investing while paying down debt and when it makes sense to invest, and when it makes better sense to pay down your debt instead.
When You Should Focus on Debt and Avoid Investing
There are quite a few circumstances when you should focus on paying down debt instead of investing. The biggest example I can think of when you want to pay off debt first is when your debt is costing you a higher interest rate than what you would earn in the stock market.
Think of it like this: if you are a conservative investor, you may only earn 3-4% in the market this year. If you are more aggressive, you may push 6-8%. However, if you have debts that are charging you an interest rate of, say 10%, you would be better off paying off the debt first, and then investing.
When Debt and Investing are Okay
I’m still a firm believer that there are situations when having debt and investing are compatible. But once again, it goes back to the formula above – if you can earn more in the market than your debt is costing you.
For example, if you have federal student loan debt, your interest rate is probably 6.8%. However, you get to deduct your student loan interest from your taxes, so your effective student loan debt rate may only be around 4%. You can probably achieve a return equal or greater to this in the stock market, so it may be wise to just make regular student loan payments, and contribute to an investment account, like an IRA.
What are your thoughts on investing and debt? Should you invest if you’re in debt?
Jason @ WSL says
I like the follow-up post (thanks for the mention too)!
I would have to agree with you about investing in the Roth IRA. All of our student loans are around 6% so I think it’s best to pay those off instead of investing. Even after the deduction (4% interest rate) I’d rather take the guaranteed payoff than the unknown of what my money might do in the market.
However, if you are in debt I’m a big believer in taking the company match in a 401k/403b/457 even before your debt it totally paid off. That’s 100% return and far surpasses the interest rate you’re paying on the debt. Saying that, I do recommend to my clients that they eliminate high-interest rate credit cards and payday loans prior to taking advantage of the company match. Although the math suggests otherwise, I’ve noticed that my clients feel much better (and more motivated) knowing those high-interest rate cards/loans will be eliminated soon.
Robert says
I agree on the company match as well – there is no reason to leave free money on the table!
There is also a value to be placed on being debt free that is hard to monetize, which could be factored in as well.
Six figure investor says
The main constraint i see here is that for the Roth (in particular) has contribution limits that go away each year. You can always pay off debt more but you cant contribute to catch up.
So there is good reason here to start early.
This question also comes down to discipline. If youve changed you habits to the point that you are managing debt well go ahead and invest. You will be making progress even if the diferences in returns mught suggest otherwise.
Robert says
Good point on contribution limits for certain accounts – I didn’t even think about that.
Lance @ Money Life and More says
I think you should always go for your employer match in retirement accounts. Past that if you have high interest rate debt pay that off first. If it is really low and fixed (4-5% and less) you could invest if you felt comfortable but remember paying off debt is a guaranteed return.
Robert says
Yes, debt is a guaranteed return, but it is risk vs. reward in each circumstance.
Money Beagle says
If your employer matches any retirement contributions, you should always participate up to that level no matter what. If they contribute 3% to your 6%, think of that as an automatic 50% rate of return. That beats out just about any interest savings you’d get paying a loan down faster. After that match, though, focus on the loan.
Jacob @ iheartbudgets says
I am in the same boat as Jason, except I don’t have any money extra at the end of the month to invest. I do, however, invest for the employee match because I barely notice the hit in my paycheck (only investing at 3%) and it lowers my tax burden.
I do have student loans at 6.8%, trying to kill them as soon as my income raises. But I want them gone (a guaranteed return) before I invest (not guaranteed return).
Maybe if I was more confident in my investing skills I would opt to tackle both at the same time.
Andrea says
This is one of the most debatable issues. Personally I feel, it depends upon the situation. It depends on many factors such as your debt type, interest rate, risk tolerance and your attitude towards debt. Paying mortgage vs. saving for retirement is an ongoing debate, I don’t see an end to it anytime soon. The most common advice is to pay off your consumer debt (credit cards and car loans) then start investing while paying down your mortgage and student loans. The rule of thumb is that the after tax return on your investment should be better than the interest rate you are paying on your debt. I thoroughly enjoyed reading your advice.
Mac Hildebrand says
Expecting a 6-8% return in the stock market assumes wise investing strategies and negative risk staying dormant. It should be noted that paying down debt is a sure investment. You can count on those numbers of dollars being saved. It is not as exciting as making money in the stock market, but it can be counted on. Most credit cards have higher interest rates than investment returns, so the situations will be very few when considering investments is worth it.
jim says
I was too stupid to even think about this when I was in my very late 20’s – the first time we were even making a semi-decent income (heavy emphasis on the “semi”). So we just kept paying on our (humongous) student debt loan (at much higher interest rates than today’s) and automatically contributed to our 401(k)’s. Hell, we thought the 401(k) investments were a requirement, like taxes and/or health insurance payments. Who knew stupidity could pay off? I’d do IT all over again, just like that, ’cause you do NOT want to lose the power of that compounded interest. And, when you’re paying off your student loans you’ve usually got little ones that keep you so busy, i.e. exhausted, you don’t have time to spend $ otherwise – so pay off your loans AND contribute to your 401’s simultaneously.