Priority: Paying off Debt or Investing

I have seen quite some debates on whether a person in debt should focus on high interest debts first and defer any investing until all the debts are paid off, or the two can be proceeded simultaneously. Depending on the goals of saving/investing, my arguments for taking the latter approach are:

  • For long-term goals, such as retirement or kid’s college tuition, the length of the debts will be relatively short;
  • A small amount ($50 or $100) invested every month from now could mean a big pile of money 20 or 30 years later (check my analysis of investing $100 in a low-cost mutual fund for 20 years)

In this case, the benefits of starting early are indisputable. For me, I don’t have any debt other than home loan and car loan which both carry about 5% interest rates, and I am in no rush to paying them off as I believe I will be better served to invest the money (though I put an extra $400 every month toward home loan, that’s outside my monthly investments). However, it’s never a good idea to borrow money in order to invest. That will get people further in debt as the stock market is never predictable and a bear market can last for years.

In the short-term, those credit card debts should get a higher priority as the money should go to the place that generates the most benefits, but in my opinion, investments, if possible, shouldn’t be delayed in this case either (here are some ideas to start investing a small amount every month).

There’s an article on Kiplinger’s Personal Finance today making the case of “Should you be putting money in savings accounts or investments at the same time you’re paying off a loan?” The author offers three steps for people who face this problem.

Step 1: Pay off the high-interest debt

It doesn’t make sense to start saving or investing if you have high-interest credit card debt as the returns from stock investments are unlikely to surpass the interest rates of the credit card debt which could be above 15%. But if your employer offers a 401(k) plan with a match to a certain level, you should fund your plan up to that level to get the free money.

Step 2: Identify the good debt

Usually, it’s not a good idea to pay off your home mortgage unless you have a lot of extra cash. In this case, the money should be invested instead. Also, if you have student loan, you should be in a rush to pay that off, either. But it always pays to shop around for the best rates.

Step 3: Save and invest

Once the high-interest credit card debt is taken care of, you should start saving as much as possible. Set aside enough money to cover any emergency, participate in the 401(k) plan your employer offers, and open an IRA account.

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5 Responses to “Priority: Paying off Debt or Investing”

  1. Lazy Man and Money |  Feb 01, 2007 at 4:12 pm

    “However, it’s never a good idea to borrow money in order to invest.” If you want to lend me some significant amount of money at 1% interest for the next 30 years, I’ll be happy to borrow and invest it ;-). My point is that if you can acquire more of that good debt you talk about to either invest (or pay off the bad debt) you should.

  2. The Sun |  Feb 01, 2007 at 5:25 pm

    Well, I will borrow as much as I can as well for anything at “1% interest for the next 30 years” if that kind of loan is available :)). What I meant was borrowing short-term money to invest (like 0% balance transfer for 1 year) isn’t a good idea.

  3. moneymonk |  Feb 01, 2007 at 5:32 pm

    The less debt you have , the more you can save! It’s always best to get rid of the high rate debt to free up money for saving and investing.

    401k and IRA both also can give tax breaks. So it’s good to start with these investments

  4. The Sun |  Feb 01, 2007 at 10:03 pm

    While I agree with you that one should concentrate on the 10+% debts first, investing $50 a month won’t change the debt elimination plan a lot. However, $50 today will make a big difference 20 years later. My argument is more like making investing a habit instead of an impulse.

  5. Golbguru |  Feb 02, 2007 at 2:10 am

    Sun, while I do borrow from 0% offers and invest them else where..there is a school of thought which says that less debt means less stress.
    There is some kind of a psychological barrier that keeps some people stressed out about being in debt…even thought it charges low interest rates. With this thought, the relief that $50 reduction brings to some people might be much more valuable than the value of $50 20 years later.
    Just to be clear, I don’t belong to this category of people, but in the last Festival of Under 30 finances, I heard this sentiment a lot.