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Whether to invest when you’re in debt depends on the kind of debt you have as well as other factors. Here’s how to decide.
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If you’re like most people, there are a lot of things you want — and need — to do with your money. For example, if you owe money to creditors, chances are good you are going to want to focus on repaying it. But, you may also want to invest your money so you can start earning returns and building wealth.
The big question is, should you open a brokerage account and start investing while you’re still working on paying debt or should you become debt-free first. In order to make this decision, there are a few key questions you need to ask yourself.
What kind of debt do you have?
The first thing to think about is the kind of debt you have, as well as how expensive that debt is.
For example, if you owe money on credit cards, you may be paying a high rate. The average interest rate on a credit card is around 20.09%, according to the Federal Reserve. If you pay off your cards early, the return on investment (ROI) you get is the amount of interest saved. So, your ROI for early payoff would be a little over 20% if your cards charge around the average rate.
It’s pretty unlikely you’re going to find many reasonably safe investments that are going to consistently earn you a 20% annual return on investment. So, you’d likely be better off trying to pay your cards off first before shifting your focus to investing.
If you have low interest debt, though, then you may be better off just paying the minimum and investing the rest. For example, say you have a mortgage loan at 3.25%. Since you can reasonably expect to earn about a 10% average annual return (before inflation) if you invest in an S&P 500 index fund (a pretty smart investment) over the long-term, you’d typically end up with a much higher net worth. So focus on investing extra money rather than using it to pay down your home loan.
How quickly could you become debt-free?
The next big thing to think about is how long becoming debt-free is going to take you. If you can get serious about your debt payoff and wipe your balance clean in a few months, then it may be worth delaying a shift to investing. You can eliminate what you owe, no longer have the monthly payment to worry about, and free up cash you were sending to your creditors to invest later.
But if it is going to take you many, many years to pay down your debt — even with extra payments — you may not want to wait to get your money into the market and working for you. Due to compound interest, your brokerage account balance can grow a lot bigger if you invest early because your returns will start earning returns that can be reinvested. The more time you give compounding to work, the easier it is to build wealth.
What investment opportunities are available to you?
Finally, think about what investment options you have. For example, if you have the ability to invest in a workplace 401(k) that offers an employer matching contribution, you should focus on maxing out that match as soon as you’ve made your minimum debt payments. Your employer’s contribution is free money that could provide up to a 100% ROI if you get a dollar-for-dollar match. It is not worth passing this up to pay off debt early.
By considering these issues, you can decide whether to invest while you’re still in debt or whether eliminating creditors from your life should be your primary priority.
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