The age-old question: should you prioritize paying off debts or investing?
Or if you are ambitiously trying to do both: To what extent should you prioritize each one?
The answer is not the same for everyone. From the outside, it’s easy to say, “Don’t invest until you are out of debt.” Or: “The market has higher returns than your loan interest, so why should you pay it back?”
However, it depends on what you are comfortable with. (I know – lame answer, right?)
However, if you’re a numbers person and my editor won’t let me finish this post, let’s go into some specific numbers to help you decide whether to prioritize paying off debts or investing.
Should You Pay Off Debt or Invest?
There are many factors to consider: interest rates, amount of debt, income, expenses, etc.
But to invest money on it, after your monthly expenses, you need to have a surplus that you can use for retirement or debt.
The quickest way to do this is to cut your expenses and / or increase your income. But even after that, people will have different surpluses depending on where they live, life situation, etc.
Someone with enough surplus to pay off $ 50,000 in two years should think about investing differently than someone who takes 10 years to pay off.
So let’s look at the fictional examples of Adam and Sharon. Both are 25. Both have a debt of $ 50,000 and pay an average interest rate of 6.45%.
Adam has a considerable excess. He plans to pay out $ 50,000 in two years from his wife’s income, sideline, and cost cutting.
But Sharon has very little excess. So she plans to repay her $ 50,000 in 10 years.
Why Adam may want to invest while paying off his debt …
If Adam sticks to his plan of investing all of his surplus in paying off his debt instead of investing, he will make 24 payments of about $ 2,226 and pay just over $ 3,400 in interest.
For example, let’s say Adam uses some of his surplus to maximize his Roth IRA by investing $ 6,000 per year. In the end, he will make 32 payments of $ 1,726 instead of 24 payments of $ 2,226. He pays additional interest of $ 1,000.
But he will have to invest two more years of Roth IRA contributions – $ 12,000.
$ 12,000 alone, which added up over 35 years in a 6% return market, will grow to $ 92,000 by the time Adam is 62.
Although he will be paying additional $ 1,000 in interest because Adam is paying back his loans so quickly, the use of some investments in paying off his debt would earn him an additional $ 90,000 in the long run.
… But Sharon should focus on getting rid of debt
If Sharon pays off her debt of $ 50,000 over a 10-year period, she will make 120 payments of approximately $ 570. She pays a total of around $ 18,000 in interest.
If she starts maximizing her roth when she goes debt free – by age 35 in 10 years – she will have contributed $ 30,000 by the age of 40. If she continues to contribute $ 500 per month from 36 to 60 years old, she expects 6% growth I’ll have $ 304,000 by the age of 60.
If Sharon decides she doesn’t want to wait to invest and puts $ 50 a month on her Roth IRA, she’d end up making 137 payments of $ 520 plus more than $ 2,700 in interest pay for their debts. During that time, she has deposited $ 6,850 into her Roth. With 6% growth, the balance would be $ 8,357 if it was debt free.
That equates to $ 1,507 growth in their Roth at the cost of an additional $ 2,700 in interest paid on debt.
Then, if she started donating $ 500 a month to her Roth at the age of 38 to 60, she would be $ 290,000 at that point – $ 14,000 less than if she had focused on her debt to settle instead of investing in that time.
Of course, no financial situation will be like Adam and Sharon’s.
The most valuable lesson from these scenarios is that you must key in the numbers for your own situation.
You may not be sticking to the strategy you’re starting with. If you don’t invest, you may spend a few months refining your budget and getting used to going out less. You may then find that you need to invest extra money or that you can pay off your debt much faster than expected.
Alternatively, you can invest for a while and then come across something that will lower your income. So it could make sense to take a short-term investment break.
As a rule of thumb, if you get the most out of an IRA and are still debt free in four years or less, it may be worth paying a little more interest to start investing.
If your budget is tight, or your interest rates are at or above the average return we use to calculate retirement savings – 6% -8% – don’t worry about your IRA.
But remember: as long as you are doing smart things like saving, paying off debt, and investing, you are already on the right track.
This article provides general information and explains the options you may have. However, it is not investment advice or a personal recommendation. We cannot personalize articles for our readers, so your situation may differ from the one discussed here. Please find a licensed specialist in tax advice, legal advice, financial planning advice or investment advice.
Jen Smith is a former employee of The Penny Hoarder.