In a nutshell:
Pay debt or start investing? Mathematically, it is best to do whatever produces the higher return. However, paying debt is likely to be the better option because of the financial and mental strain it causes.
- High interest debt above 10% should be priority
- Paying debt first is likely to be the best course of action
- Mathematically it is better to choose the option that gives the highest return
- The Dilemma
- Pay Debt
- Start Investing
- Comparing The Two
- Doing Both?
- Final Word
Pay debt or start investing? This is a common dilemma people face, and it can be a tough choice to decide which one to focus on.
Getting rid of your debt is likely to improve your wellbeing, due to not only the financial strain, but also the mental strain that being in debt causes.
Whereas investing is essential in order to build your wealth over your lifetime, with the ultimate goal being to live comfortably, retire early, and be financially free.
Lets look at each option in more detail.
Firstly, its important to consider that not all debt is bad. For example, student loans here in the UK aren’t really debt, but more a tax, where you pay 9% out of your income each year for student loan repayments. Another example is a mortgage, or using leverage to build your wealth. Debt isn’t inherently bad, although many people do misuse their credit card (see our previous post on how to best use your credit card).
However, a lot of debt that people have is ‘bad debt’, such as high interest rate consumer credit card debt. This is the type of debt that you do not want, and this type of debt needs to be paid off as soon as possible.
Debt isn’t just a financial burden
It is important to consider the effect of debt on our lives. Often, it causes a financial and mental strain, with the feeling of being weighed down. Being debt-free can make the world of difference to someone’s happiness – which is why for the average person, we think paying off debt should be the first priority!
Especially if you are paying an interest rate on your debt of 10%+, this needs to be a priority to be paid off!
With investing the earlier you start the better, this is because your money is compounding (the power of compound interest!) over more years. There are a number of reasons why you should invest,which we have talked about before on Making Money Simple, such as beating inflation, building wealth and getting to financial freedom.
Probably the most important reason to invest is grow your wealth and then retire early and more comfortably. We are not all millionaire entrepreneurs, but by investing a good part of your salary each year, and letting time and the stock market do its thing, you are likely to be a millionaire come retirement should you invest for long enough.
Grow Money Tax-free
Regardless, it is still important to consider whether investing is for you – don’t just jump into investing blindly. Do some reading and research, and make sure you make use of a Stocks and Shares ISA to grow your money tax-free.
Comparing The Two
Unfortunately, there is no concrete answer – the answer depends on your personal situation and also your personality. Generally speaking, paying off debt is beneficial because a weight has been lifted off of your shoulders, often making you feel more relieved and happier. As a result, this is likely to be the best bet for you, then once you are debt-free you can focus all of your efforts on investing.
However, mathematically, it is more beneficial to do whatever provides the highest return. For example, if you can receive 10% from the stock market, and you are only paying 6% interest on your debts – then invest, as you will have a net effect of 4%! Ultimately, the best rational decision is to do whatever gives you the highest return.
But, it is important to note, when we are talking through these examples, that the return from the stock market can vary wildly from year to year. Whereas, when paying debt, you know that if you have debt that you are paying 7% interest on, and you pay of all of this debt, then you have got a return of 7%!
There could be an argument to pay debt and invest at the same time. For example, if your debt is earning an interest of 10% per year, and investing could also earn you 10% per year, mathematically it can make sense to do both.
We would suggest only to do both if your debt is under control. It is no good starting to invest some money, only for your debt to keep on growing.
Like anything in life, when you focus all your efforts in one area, that area will get done quicker. It is better to focus on paying off all of your debt, even if that will take several years, rather than half-heartedly doing both – and then not really achieving a debt-free life or a financially free life.
So, pay debt or start investing?
Whilst not concrete, weighing up both sides, we would advise to pay off your debt first, particularly high-interest debt. Once you have this sorted, then you can focus on investing money each month to start slowly compounding your wealth over time!
Regardless, the end goal, with persistence and discipline, should be a debt-free life where you also are able to one day live off of your investments!