Is paying off debt first always the correct decision? Sometimes, people with excess cash are forced to reckon with a difficult financial decision: should I use the money I have right now to pay off a large debt (such as a student loan), or would I be better off investing these funds instead? For some people, this is a no-brainer, right? They would just pay off the debt as fast as they could, avoid the interest and get busy saving again.
But as you probably already know, it's not always as simple as that. There are a lot of other factors to consider besides just being debt free. While everyone’s financial situation is unique based upon their values, goals, and resources, we've come up with some productive ways to help you think about the problem and make an informed, rational decision. (For more, see: When Paying Down Debt Doesn't Make Sense.)
The First Question to Ask
The first question you have to ask yourself is a pretty simple one. Which amount is higher: the interest you'll pay on the debt if it remains outstanding or the return you're likely to receive using the funds somewhere else? If you're comparing 12% on $25,000 credit card debt to an investment that might net you 5%, the answer is easy, right? Remember by paying off a debt with a 12% interest rate you are essentially earning a 12% return on your investment.
But things get more complicated if your investment opportunities are more attractive. If in the above scenario you had a well-researched investment that could earn you closer to 18% to 20%, then you have another question entirely. Absent any other information, your decision hinges on how likely it is that the investment will pan out and how much risk you are able to take on. That's when you'll need to consider various other factors.
Other Factors to Consider
Here are some of the most important factors to consider when deciding whether to pay off a large debt or invest your excess cash.
- Your current balance sheet: Do you have any other large debts? Do you have an emergency fund? Are you disciplined enough to not accrue anymore debt if this is paid off? Are you investing at all?
- Your risk tolerance: If you don’t know your risk tolerance, I suggest you read this. Once you understand your tolerance level, be confident that you can absorb the emotional and financial consequences if you choose to invest the money somewhere else and the investment goes poorly. If the answer is no, then it's clearly better to pay off the debt.
- The role of compound interest: If you choose to pay off a large debt, you won't necessarily benefit from the power of compound interest that a good investment can unleash. You can't go back in time and gain compound interest retroactively, so you'll need to factor in the limitations of your time horizon and weigh them against any potential growth. (For more, see: To Invest or to Reduce Debt, That's the Question.)
Student Debt Versus Investing
Although you should still apply the above criteria when your decision involves student loan debt, there is another wrinkle to consider. Since interest rates on student loan debt are relatively low (and can be locked in low), if your time horizon is long you should be able to locate investments that yield a higher return. This is especially true in your 20s and early 30s when you have ample time to let compound interest work its magic on your investments.
If you can lock in a 3% loan, while investing excess cash toward your retirement at 5%, I wouldn’t be in a super hurry to rush and pay down the debt. You don’t have to invest all of your excess cash - you can do a portion toward each.
Lastly, you can always borrow for school but you can’t borrow for your own retirement, so don’t neglect to pay yourself.
So, do you pay off student loan debt or invest? It really just depends on your personal situation and what makes the best financial sense for you in this exact moment. In many cases, it can make a lot of sense to create a plan to pay down your student loan debt within a defined time period and invest toward your retirement. It doesn’t always have to be one or the other. (For more from this author, see: Have This Financial Conversation Before Marriage.)
To learn more about working with a financial advisor, you can download the free guide, "The Ultimate Guide for Choosing Financial Advice."