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How to decide whether to pay down debt or invest your money

November 22, 2022, 6:00 PM UTC
Photo illustration of arrows made of 100 dollar bills going down and up.
Paying off high-interest credit cards should be a priority in the current rate environment.
Photo illustration by Victoria Ellis/Fortune; Original photo by Getty Images

When you’re bogged down in debt, whether it’s credit cards, loans, or some combination of both, setting aside money to invest can be challenging. It can also feel somewhat counterproductive investing when you’re paying interest on debt.

With household debt in the United States skyrocketing to $16.5 trillion in the third quarter of 2022—which is more than $2 trillion higher than prior to the pandemic in 2019—more than a few people are likely to be facing this dilemma. Does it make more sense to focus on eliminating debt or investing? And under what circumstances should you try and do both at the same time? The answer to those questions won’t be the same for everyone.

How to decide when to pay off debt and when to invest

There are some key considerations to sort through in order to help gauge whether you should focus on tackling your debt or investing—or doing both simultaneously. Navigating this dilemma hinges on such variables as the interest rates on your debts, your ability to stay on top of debt payments and your retirement timeline.

Is your debt high interest credit card debt?

For those who are carrying high-interest credit card debt, it often makes more sense to focus your financial efforts on simply wiping out the debt as quickly as possible, rather than trying to invest, says debt resolution attorney Leslie Tayne, of Tayne Law Group.

“The stock market has historically returned 10% on average, while credit cards have rates that hover around 20%. Unless you aggressively pay down credit card debt first, the math won’t ever work in your favor,” says Tayne.

Tayne’s point is particularly important at a time when interest rates on credit cards have risen precipitously, which has made eliminating credit card debt even more challenging for those who are struggling—especially if you’re only making minimum payments. In 2022, credit card interest rates hit 19.04%, according to Bankrate.com. That’s the highest it’s been since Bankrate started tracking credit card rates in 1985.

Amid such an environment, Tayne is not the only one who suggests focusing on paying down credit card debt.

“We typically do not recommend investing for someone that is carrying significant credit card debt at a high interest rate because it will only continue to build and weigh on you financially,” says Nina Gunderson, a financial advisor and account vice president at UBS Financial Services. “We typically suggest that an individual start by paying down their high interest credit card debt first before evaluating other financial decisions and opportunities.” 

What is your overall debt amount?

Yet another important factor to consider is your total debt burden. This is particularly relevant if your debt is so substantial that you’re having trouble maintaining your household budget and staying current with all of your monthly debt payments.

“Carrying debt has consequences—especially if it’s high-interest or unmanageable. Missing payments on your loans and credit cards can be detrimental to your credit. That can make it difficult to borrow money in the future, rent an apartment, open utility accounts, and more,” says Tayne. 

Ongoing debt negatively impacts your credit score in other ways as well. When you are using too much of your available credit lines, your credit score declines. This is known as your credit utilization ratio. 

“For instance, if you have a $1,000 credit limit and you use $500 of it, then you have a credit usage ratio of 50%,” explains Katie Ross, executive vice president for the non-profit national financial education organization, American Consumer Credit Counseling (ACCC). “The higher your ratio is, the riskier you appear to creditors.”

Why do you appear risky to creditors exactly? Because having a high credit utilization ratio can be a sign that you’re relying too heavily on credit to make ends meet and get by. A good credit usage ratio is less than 50%, but a better number is around 30% or less.

What is your retirement timeline?

As a general rule of thumb, it’s typically best to avoid bringing debt into retirement. Therefore you’ll want to consider your retirement horizon when considering how quickly you need to pay down debt relative to your investment efforts.

However, not all debt is created equal, says Tayne. “It’s not uncommon to be paying down a mortgage as you enter retirement, for instance. But a home is an asset that can provide housing stability, appreciation, and generational wealth,” she explains. “Credit card debt, on the other hand, doesn’t offer any value. It simply eats away at your cash flow and net worth. Becoming delinquent on some consumer debts can also result in having your Social Security benefits garnished. So as you get closer to retirement, it’s important to prioritize getting rid of debt.”

But here, too, it’s a balancing act. Yes, you want to eliminate bad debt, like credit cards as retirement nears. But adequately funding and preparing for retirement is a major life priority. And it can be difficult to make up for lost years of retirement investing or the loss of compound interest earned if you start investing young and keep constantly investing. With this in mind, you’ll want to try and find a comfortable balance between paying down debt as you approach retirement and maintaining steady levels of retirement investments.

This is particularly important if your employer offers matching contributions to a 401(k) retirement plan. It’s a good idea to avoid drawing down investment efforts so much that you miss out on such matches. “You should always contribute enough to qualify for the full match. Otherwise, you’re leaving free money and decades of compounding returns on the table,” says Tayne.

How to do both: invest and pay down debt

For many people, it is entirely possible to do both—invest and pay down debt. And in fact, that’s the path most experts recommend so that you’re prepared for retirement. Here are a few steps that can help you achieve a balance between investing and eliminating debt.

Establish an emergency fund: One of the ways to help keep you on track when trying to do this is to prioritize creating an emergency fund with at least enough money to cover your bills for six months, says Tayne. “That way, you can avoid racking up more debt if you’re faced with a large, unexpected expense,” she explains.

Consider debt relief options: Yet another step to consider is establishing a debt management plan to help lower your debt. “If you’re paying off large debts, you might not be able to invest as much money as you want into your retirement account,” says Ross. A low-cost debt management plan simplifies your bills.” When you establish a debt management plan, a debt management counselor will negotiate with creditors on your behalf to help lower your monthly payments and reduce interest charges. The money you save through such efforts can be put toward investing for retirement. 

Find a side hustle: Increasing your household income is another way to more quickly eliminate debt and generate the cash to invest. With the proliferation of the gig economy this has never been easier. Consider finding a side job you can easily work into your routine to help rid yourself of debt more quickly.

The takeaway

With credit card rates skyrocketing, it has become increasingly important to focus on eliminating high-interest debts. But most experts agree that you should try to find a way to continue investing. Retirement savings is a major life priority and lost years of interest earned are hard to regain. If necessary, find a side hustle to help you eliminate debt more quickly, so that you can get back on track with your investment efforts.

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