Debt versus investing: A simple solution!
So I have often thought about and read about the idea of which is better when it comes to debt versus investing. Pay down debt or invest. This comes up a lot in forums, blog posts, etc. It seems to be a perpetual question and I get it. Who wants to be sitting in debt! Being a slave to the man! Screw that. It sucks and it can definitely limit all future choices…. but on the other hand, we all want to build our net worth. We all want to build wealth. We don’t want to funnel cash into debt when it could be earning 2 or 3 times in the market. So what to do… what to do?
Debt versus investing
Max out all 401Ks if there is a company match available
First off, max out all 401Ks if there is a company match available. Free money is free money. Consider maxing out IRA accounts too due to the tax savings (if you make <$117,000 as a single filer or <$184,000 if married) and the beauty of the backdoor IRA otherwise. Okay, now that we have that out of the way, what about debt versus after-tax investments accounts?
Well in some ways deciding if and which debt to pay is easy. If the debt is high interest, which I would qualify as over 6%, then pay it off! Get rid of it! Imagine that it is some hot oil sitting on your skin, waiting to be lit on fire. It is no good and needs to go bye-bye; not today, not tomorrow, but yesterday. Obviously credit card debt falls into this category and should be paid down first.
After credit card debt, it is possible some of our readers have student debt in the 5% to 6% range. My wife did. If you graduated in the late 2000’s then interest rates had started to creep up and lenders took full advantage of all the people who wanted to go to school. It still astounds me that lenders can get away charging more in debt (subsidized by the government) to get an education then if you buy a home or car. So take a look at all of your debt, determine what is accruing interest at over 6% (or 5% if you want to be conservative) and pay it off. Don’t think about investing in “after-tax” accounts until this is done.
Now comes the harder part.
What about debt that is lower than 5% or 6%? Lower than expected returns in the market? Some will say just pay down the debt. Get rid of it and don’t be a slave to any lender or job. There is some wisdom to this and I cannot argue it is a bad path. Others would argue, invest it all in the market, as you will likely earn more over the long run then you will have to pay in interest. If you have a loan at 4% interest and you earn 7% in the market, then you are up 3%. This makes sense! Its relatively simple math.
Honestly, I don’t think one is right or wrong.
I think you should do what will lead to less stress going forward. If paying off debt is your thing (it certainly is yours…add some you in here), then pay it off and don’t worry about the returns you could have earned. You never know when the market may crash again and then you would have wished you paid down your debt instead of invested in the market. (My wife would like me to point out that paying down debt is definitely my thing. It makes me twitch and itchy and I can’t wait to get rid of it). If you want to see the money pile up, then save and invest and pay down the debt slowly.
What about another option?
Okay, so this next plan is what I did before I wanted to be debt free. Take the amount of extra money available at the end of the month for investment, let’s say $1,000, and do the following: invest 70% in the market and take the other 30% to pay off lower interest debt (remember less than 5%). In essence use debt pay down as safe investment or bond like allocation. The debt pay down is a guaranteed return of the 3% or 4%. This plan is good for the individual looking to pay down some debt and invest at the same time.
So here is the break down:
· Max out 401Ks to ensure to get a company match. Consider contributing to an IRA.
· Pay off all high interest debt (5% or 6%)!
· Decide what to do with your extra money. Let’s say the hypothetical $1000 a month.
o Plan 1: Pay $1000 a month towards debt until it is all gone.
o Plan 2: Pay $1000 a month towards investments. Choose your allocation and stick to it.
o Plan 3: Take the $1000 and place 70% ($700) towards aggressive investments (stocks) and 30% ($300) towards debt payment. Feel free to play around with this allocation. Go 50/50% or 40/60%. Whatever works for your family
So what do you do regarding debt pay down versus investment? Plan 1, 2 or 3 above?
