This is the fun part of managing personal finances! Seriously – once you have all your bills paid and have secured some extra funds…you get to decide what to do. YOU are in charge of that money and YOU call the shots. You’re in a position to make money decisions and that’s FUN. But if you read my post on prioritizing financial goals, you got a quick answer to the question: should you pay off debt or invest?
What was that short answer? If your debt’s interest rate is less than 5%, you should invest while you make minimum payments on your debt.
But if you want to know why…well, I’m going to start with…
A Word of Encouragement
Here’s the deal: money is emotional. In theory, it’s a tool to help us operate in our capitalist society. But in practice, we are inundated with many messages about how much money we should have (and how we can show that we have it). Layer on top of that the fact that not all of us live in a financially stable home, and that leads to a lot of financial fears.
So before we get into the nuts and bolts of how to decide what to do with your money, I wanted to point out a couple things.
1. Every dollar counts
Deciding what to do with your funds can be overwhelming because there are so many competing financial priorities and it’s easy to get to a point where you can only spare $5 for a goal. But that’s okay! $5 can make a difference, if you’re consistent about it.
2. What is right for you is right for YOU
What I’ll be laying out in this blog is a logical way to deduce how to use your money to maximize its impact on your net worth. But that completely disregards the effect on you emotionally. Again, money is emotional! So if you need to pay off all your debt to feel secure (even if it’s low-interest) or if you need to invest now to feel secure (even if you have high-interest debt), you do you. But I’m going to share the math to help inform those decisions.
So…Should You Pay Off Your Debt Or Invest?
When it comes to wealth management, the ultimate aim is to use your money to make more money. Passive gains are the path to financial security. That’s why people invest. So when your finances are stable enough that investment opens up as an option, you need to shift your mindset from, “What can I spend this money on?” to “How can I put this money to work?”.
Mr. Money Mustache (a big personality in the financial independence community) describes his money as, “…tireless employees, that end up working much harder than you do.” And I agree! So let’s look at two ways you can turn your money into employees.
Employing your Cash Employees as Investments
This is probably the first thing that came to your mind when you thought about using your money to make more money, for good reason! But what can you expect from the stock market?
There’s probably enough to cover about investing that I could write a whole other post, but let’s cover the basics real quick. When you invest in stocks, you are buying a small part of ownership in the company. In return for fronting the money, the company will either distribute profits to the stockholders through dividends or dedicate that same profit to building the company, driving up the share price and increasing the chance of the stockholder making a profit when they sell the stock.
While you can buy stocks from individual companies, the more stable investment is in mutual funds or total market funds – basically big buckets of stock. By buying a lot of different stocks – “diversifying your portfolio” – you protect yourself from the volatility of any individual stock.
So what can you expect from the stock market? While it is impossible to predict just how much money you’ll make from the stock market, many many economists have spent their lives researching and have come up with a rule of thumb.
In general, the stock market will return about 7%. In other words, every dollar you invest in the stock market will be worth about $1.07 in a year. But the US also generally sees about 2% inflation annually (so your dollar today will buy about $0.98 worth of goods in a year). So common wisdom holds to expect a 5% annual return on your investments.
Remember that number.
Generally, credit card interest rates are WAY higher than 5% – so pay that noise off ASAP.
Employing your Cash Employees as Debt Payoff
Paying off debt doesn’t feel like it’s making you money like investing would, right? But it actually does! When you make extra payments on your debt, you are getting out of later interest payments. In other words, you’re saving Future You the amount you would have paid in interest.
This is why I brought up investment returns earlier – the *~logical~* way to know if you should pay off debt or invest is to compare your debt interest rates to expected market returns.
Example time. If you’re paying 3.5% interest rate on your debt, every extra dollar you pay today toward that debt means you DON’T pay $0.035 when that extra dollar was due. Meaning you’re getting a 3.5% return. But if you took that same dollar and invested it, you will likely make $0.05 on it. So it will be better for your net worth to invest it.
Summary
Like I said at the beginning, if the interest rate on your debt is less than about 5%, go ahead and invest while making minimum payments on your debt. It’s statistically the most efficient use of your funds.
But don’t forget to allow yourself space for your emotions about money. Which sounds super woo-woo, but they’re real! And ignoring them is just going to make you feel like a failure. Which seems like a waste of time, to be honest.
So let your interest rate comparison drive your logical argument, but be sure to balance it with how comfortable you are with holding debt. Drive your net worth, but balance it with mental well-being.
Because at the end of the day, I pay attention to my finances so that I can spend my time and effort on the things I care about. Wouldn’t you like to do that, too?
