Should You Pay Off Debt or Invest?

There’s no one right answer for whether you should pay off debt or invest. It depends on how you typically manage your money and what your risk tolerance is.

But from a money-making standpoint, sometimes it makes sense to pay off debt rather than invest. For example, it’s often better to pay off high-interest debt before investing so your debt doesn’t get out of control.

On the flip side, if you have a relatively small amount of debt, the right move could be to put some money toward your debt and invest the rest.

How to know if you should pay off debt or invest

To know whether it might make sense to pay off debt or invest, consider these four questions:

1. How much debt do you have?

If the amount of debt you have is relatively small, it probably makes sense to invest your extra money outside of your debt payoff plan. This is because a small amount of debt isn’t likely racking up much in interest charges.

But if you have a large amount of debt, you should pay it down so you don’t rack up more debt through interest. Interest charges can accumulate quickly and cost you more in the long run than if you’d prioritized paying down the debt in the first place.

2. Is it high-interest debt?

One of the biggest issues with debt and why it can spiral out of control is interest. If your debt has high interest rates, it often makes sense to pay it off as quickly as possible or try to get a lower interest rate.

Compound interest is especially important to understand in this situation. Compound interest basically means your interest earns interest. That’s a good thing when it comes to your investments, but it can be scary for personal loans or credit card debt that continue to grow exponentially due to compounding interest.

3. What kind of returns do you think you can get from investing?

Investing is inherently risky and doesn’t come with guarantees. But some investments have historically offered regular returns. It might be worth investing your money if the expected rate of return is higher than your debt’s interest rates.

4. How much extra cash do you have?

If you don’t have much extra cash to work with, the safest bet is to prioritize paying off your debt. But if you have a bit of wiggle room, you could consider investing some of your money. It could also make sense to find a balance between paying off some debt and investing some money.

Keep in mind that you might have access to valuable financial tools that can help boost your investments. For example, many companies offer 401(k) matching, which typically means an employer will match your 401(k) contributions up to a certain limit.

If your employer offers a 3% 401(k) match, that means they’ll match up to 3% of your own contributions, which is potentially double your contribution amount without you having to invest more cash. It’s basically free money you don’t want to miss out on if your company provides matching.

When you should pay off debt rather than invest

Let’s say you have two credit cards with high balances and high interest rates:

You’re unlikely to get investment returns high enough to counteract such high interest rates. Simply having a savings account or certificate of deposit isn’t going to be enough. Even investing in the stock market might not be enough, and it’s more risky. If you don’t focus on paying down these balances, you could quickly find yourself paying thousands of dollars in interest.

For example, making a relatively low payment of $300 per month toward the credit card with a $15,000 balance could take you 106 months (8.8 years) to pay off the balance. And during that time, you’d pay more than $16,000 toward interest.

In this case, it makes more sense to focus on paying down your two credit card balances rather than investing extra cash because your debt could continue to increase and get out of control.

When you should invest rather than pay off debt

Let’s say this is your debt situation:

This scenario is simple because you might have a large loan, such as a mortgage, with a relatively low interest rate. All you basically have to do from a money-making standpoint is stand to earn more on your investments than you’re paying in interest on your debt. And at that point, it might make sense to invest rather than pay off debt.

This doesn’t mean you shouldn’t make your required minimum payments. But if you have extra cash beyond making the standard monthly payments, it might make sense to invest that money rather than putting it toward your debt.

There’s no way to know for sure that you’d earn more on your investments than the interest on your debt, but historic returns are in your favor. The annualized return rate of the S&P 500 over the last 10 years is 11.24% as of 2022. That’s more than double the 5% interest rate on your hypothetical loan.

How to pay off debt and invest at the same time

You don’t have to completely commit to paying off debt vs. investing. You can also find a balance between the two and work toward achieving multiple financial goals at the same time.

The primary goal of this strategy is to split any extra money you have between both paying off debt and investing. This means first making all your required minimum debt payments and paying for essential expenses, including food, utilities, and an emergency fund. And then putting any leftover money toward debt and investing.

It could make sense to consider debt consolidation if you need help managing your debt or you want a lower interest rate. This strategy combines multiple debts into one so you aren’t dealing with various balances and interest rates.

If you need help on the budgeting side of things, check out our list of the best budgeting apps.

FAQs

Pay off debt or invest: bottom line

Whether you should pay off debt or invest depends on your financial situation and your general approach to money management. From a purely financial perspective, it makes sense to invest extra cash outside of your low-interest debt payments because you could end up with more money in the long run.

If that makes sense to you, check out recommendations from our list of the best investment apps.

On the flip side, if you have a lot of high-interest debt, such as credit card debt, then you should prioritize paying it off. You may also want to prioritize paying off lower-interest debt if you value complete financial independence. After all, it’s hard to put a price tag on peace of mind.

If that’s how you feel, learn more about how to pay off debt.

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