Should You Pay Off Debt Before You Start Investing?

The pros and cons of using your pension pot to pay off debt - bdhSterling

Carrying high debt balances can feel like a weight on your shoulders, and deciding whether to pay down debt or invest can be challenging.

So, should you focus on reducing your debt, or should you put your money into retirement savings or other investments? There’s no one-size-fits-all answer, as everyone’s situation is different.

Here are a few factors to consider that can help you make the right decision for your circumstances.

WHY YOU MIGHT INVEST FIRST

HOW MUCH DEBT ARE YOU CARRYING?

If your debt is relatively low, it might make sense to invest your extra money. A small amount of debt usually doesn’t accrue significant interest charges.

However, if you have substantial debt, paying it down might be wiser to avoid racking up more interest. Interest charges can quickly add up and cost you more in the long run.

YOUR RETIREMENT INVESTMENT

Many employers match 401(k) contributions up to a certain percentage, typically between 3% and 5%. This employer match is essentially free money and a part of your overall compensation package. Not taking advantage of it is like giving back part of your salary. Prioritize getting the full match over paying down debt.

Additionally, there’s a tax benefit to investing in your 401(k). Contributions to tax-advantaged retirement accounts like your 401(k) are made with pre-tax dollars, which can lower your taxable income in the short term.

IF YOU RECEIVE EXTRA CASH

If you receive extra cash, such as an inheritance or a work bonus, first shore up your emergency fund. For smaller windfalls, consider splitting the cash between debt repayment (60%) and investment (40%). This approach can help you reduce debt faster while still investing for the future.

WHY YOU MIGHT PAY DOWN DEBT FIRST

DEBT INTEREST RATE

High-interest debt, like credit card debt, should be a priority to pay off. High-interest rates can make it difficult to get ahead financially. If you’re investing while carrying high-interest debt, you’re likely paying more in interest than you’re earning on your investments, resulting in a net loss.

TO BOOST YOUR CREDIT SCORE

Paying down debt can improve your credit score, which can affect various aspects of your life, such as insurance premiums, rental applications, and even job opportunities. A low credit score can lead to higher interest rates or difficulty obtaining loans.

Credit scores are influenced by factors like your credit utilization ratio, which is the amount of credit you’re using compared to your available credit. Lowering your debt can significantly boost your score.

CAN YOU PAY OFF DEBT AND INVEST?

You don’t have to choose between paying off debt and investing. You can find a balance and work toward multiple financial goals simultaneously.

STRIKING A BALANCE BETWEEN FINANCIAL GOALS

Focusing solely on paying off debt might seem like the right approach, but failing to save or invest during this time can leave you with no savings when you finally become debt-free. By allocating some money to savings while repaying debt, you can progress toward important financial goals, like retirement savings through your company’s 401(k) plan, while eliminating debt.

PAYING OFF DEBT IS IMPORTANT, BUT INVESTING IN YOUR FUTURE IS TOO

Consider scenarios where you might become disabled or lose a spouse unexpectedly. Without proper protection and income strategies, the costs of dealing with such situations can far outweigh the interest on your debt.

THE BOTTOM LINE

Paying off debt can bring short-term financial rewards, while investing can benefit you in the long term. Before deciding whether to prioritize debt repayment or investing, crunch the numbers. Aggressively paying off low-interest debt or debt tied to appreciating assets, like real estate, might not be the most financially advantageous move. If investment gains are higher than the cost of financing your debt, it might be worthwhile to invest while continuing to make minimum debt payments.

However, prioritize paying off high-interest credit card balances, as this type of debt is expensive and can negatively impact your ability to access cheaper credit in the future, ultimately costing you more and affecting your quality of life.

Weigh all factors carefully to determine the best approach for your situation.

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