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Finance

Is it Better to Invest or Pay Off Debt?


One of the perennial questions in the sphere of personal finance is whether it is better to invest or pay off debt. The answer is nuanced and there is no one right answer for anyone.

Money has to be invested in the stock market for as long as possible. Time is required so that capital gains and dividends can be accrued and re-invested on a consistent, long-term basis. In other words, compound growth works best when given a long time horizon. These facts favour paying the absolute minimum on your debts while investing money into the market.

On the other hand, paying debt for longer than necessary means that you’re sending interest payments to creditors. Consumer debt can have double-digit interest rates. Unless you’re paying 0% interest on your debt, you can be guaranteed that you’re paying interest to someone for the privilege of having borrowed their money. Debts have a way sticking around much longer than we’d like. From that perspective, it makes sense to pay off debt as fast as possible and to delay investing.

Both good options. Which one is best?

This is where nuance must be applied. Each person’s situations is different. Yet, the following remains true. Dollars spent to repay money owed to creditors cannot be invested in the stock market for long-term growth. If you devote 5 years to pay off non-mortgage debt, aka: consumer debt, then that means you’ve lost 5 years of compound growth for your investment portfolio. It might take longer than 5 years to eradicate your debts. The bottom line is that your money needs to be invested today, preferably yesterday, so that it can grow as quickly as possible.

Why not do both simultaneously?

As I’ve matured and gained wisdom, I’ve started to ask myself why the choice has to be so stark. Is there a really good reason why a person cannot do both? Why not invest and pay down debt at the same time?

Presumably, you are not living paycheque-to-paycheque. This means that there’s some extra money in your budget. If there wasn’t, then this question wouldn’t even come up in the first place. The reason you’re asking the question is because you want to make best use that extra money.

Let’s say you have an extra $250 per month. Why not send half to your investment portfolio and send the other half to your debts? I call this the Half-and-Half Method.

If you invest on no-commission platform, then you’ll be investing $125 each month for the Care and Feeding of Future You. This is a respectable start. (As you earn more money and pay off your debt, this amount should be increased.)

The other $125 can be put towards your debt as an extra payment. Some people apply extra money to the lowest balance, in order to get rid of it faster – the Debt Snowball Method. Other people choose to direct extra money to the debt with the highest interest rate, in order to pay as little interest as possible – the Debt Avalanche Method. Personally, I like the snowball method because it delivers a sense of accomplishment sooner rather than later.

Remember that nuance I was mentioning earlier? Well, there are two factors that I look at in any situations. There are probably more, but I’ve yet to ponder them sufficiently to discuss them with you in this post.

Age

The younger you are, the longer the time horizon. For this reason, I think you can devote slightly more to your debt repayment than your investments. If you’re under 30, then I’m okay if 60% of your $250 goes to debt repayment while 35% goes to investments.

Every compound growth chart out there shows that younger people can invest much less money each month to achieve the same final amount as someone who starts investing at later ages.

That said, I don’t want you to think that investing $0 is acceptable. It is not. You should be aiming for atleast $100 per month when you’re in your 20s. Again, as you pay off debt and/or increase your income, you’ll need to increase this amount.

If you’re 30 and older, definitely use the Half-and-Half method. You don’t want debt payments in retirement, especially if you’ll be living on a fixed income. However, you’ll also want to build a nice cash cushion for your retirement. The Half-and-Half method allows you to do both.

Length of Time To Pay Off Debt

This one appears to contradict my Half-and-Half method. Still, I do like the sense of accomplishment that it provides. If you can knock out a debt in 90 days or less, then commit the entire $250 to doing so and forego contributing to your investments for 3 months.

The caveat here is that this is a one-time option. I don’t want you to delay investing for 90 days, then delay investing for another 90 days to knock out another debt, and then delay investing again. Serially focusing on paying off one debt at a time is simply focusing on paying off debt. If you pay off a 90-day debt only to incur another debt that can be paid off in 90 days, then you’re better off using the Half-and-Half method. Clearly, debt is going to be a structural feature of your life so you need to be investing atleast some of your money for the Care and Feeding of Future You.

Too Long, Didn’t Read!

Is it better to invest or pay off debt?

The answer is to do both at the same time. The need to provide for Future You does not diminish just because you’re paying off debt. Contribute to your investment portfolio while you’re paying off your debts. Eventually, your debts will go away and there will be a nice cash cushion waiting for you later on down the line. It’s the best of both worlds.



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