Over the last few years of low unemployment and strong wage growth, many Americans have run into a very good problem: They have extra money and they’re not sure what to do with it.
There’s one question about what to do with extra money that’s particularly common today: Which one is better, paying off debt or investing?
To be sure, both are important. American household debt hit an all-time high of $13.54 trillion in the fourth quarter of last year. And almost half of Americans have less than $10,000 saved for retirement.
But the question of whether it’s more important to pay off debt or invest is complicated. Today we’re looking at all the relevant variables and combining them into a simple list of debt and investing priorities.
Priority Zero: An Emergency Fund and Minimum Payments on All Debts
Let’s be clear: If you’re now coming into some money after a period of being broke (or near-broke), your highest priority is to build an emergency fund and make at least the minimum payments on all of your debts.
These are basic bankruptcy-avoidance measures that are so important that we’re printing them above the main debt-or-investing list.
The reason you need to make at least the minimum payments on any debt should be obvious. If you don’t make any payments, your debts will go to collections. Your creditors could take legal action against you (and ruin your credit score in the process). Next stop: bankruptcy.
Lacking a liquid emergency fund containing at least three months’ expenses can also be a fast lane to bankruptcy. Accidents and medical emergencies can happen to anyone, and hospitals charge an average of $3,949 per day of treatment. Job loss is another common disaster worth saving for; it takes an unemployed person an average of 20 weeks to find a new job.
These two concerns are basic parts of staying financially afloat, while the list of priorities below deals with how to get ahead.
Priority One: Retirement Account(s)
Believe it or not, most experts advise putting some money into a retirement account before you start making extra payments on any debts.
That’s because when you take into account the tax advantages of retirement accounts (as well as the “free money” matching programs offered by many 401(k) accounts), the return on investment in these accounts is higher than the vast majority of interest rates on personal debts.
If you have a 401(k), it’s a good idea to contribute the maximum matched amount. If not, then opening up and maxing out an IRA is a smart move.
Doing so allows your money to compound tax-free in an account that is generally safe from creditors — and that’s worth spending a little more time in debt.
Priority Two: Extra Payments on High-Interest (>7%) Debt
After funding a retirement account, your next priority should be to pay off debts with interest rates of more than 7% as fast as possible.
The 7% figure comes from the average annual return of the stock market. Debts with higher rates should take precedence over any non-tax-advantaged investments because they’ll compound at a higher rate than you can realistically expect to earn from stocks.
In other words, the opportunity cost of not paying off high-interest debt is greater than the opportunity cost of not investing in stocks outside of an IRA or 401(k).
Credit card balances are a good example of this kind of debt. The average interest rate on existing credit cards is 14.14% — more than double our 7% limit.
Priority Three: Other Investment Accounts
Once you’ve funded a retirement account and paid off your high-interest debts, you might be tempted to turn to your low-interest debts. But a bit of simple math shows that would actually be a mistake.
As we mentioned in the last section, a diversified portfolio of stocks can generally be expected to earn average annual returns of 7% over a long period. Many types of debt, like auto loans and mortgages, have interest rates well below this number.
Buying extra stocks in a brokerage account takes priority over putting extra money toward those low-interest debts for a simple reason: You can use your stock market earnings to pay off your low-interest debts.
Let’s look at an example: Suppose you have a $10,000 auto loan with an interest rate of 3%. And suppose you have $5,000 that you can use in one of two ways: to make extra payments on that debt or to buy stocks in a brokerage account.
Putting the $5,000 directly toward the debt might sound like the better idea, but it leaves you $5,000 poorer — and still $5,000 in debt.
On the other hand, if you invest the $5,000 in stocks and use the annual 7% gains to pay down the debt, then you’ll keep the $5,000 while still paying $350 per year toward your auto loan (or 3.5% of the balance).
That’s enough to stop interest from accruing and to whittle away at the principal of the loan. Once it’s all paid off, you’ll still have the $5,000, and it’ll still be yielding $350 a year, which you can keep for yourself.
Priority Four: Extra Payments on Low-Interest (<7%) Debt
For reasons we explained in the last section, your lowest priority should be making extra payments on debts with sub-7% interest rates.
It’s worth nothing that interest payments on one common type of low-interest debt — mortgage debt — are tax-deductible. By giving you some of your interest payments back through your income tax refund, Uncle Sam is lowering the effective interest rate on your mortgage and pushing it further down the priorities list in the process.
Americans deal with a lot of financial stress, both from debt and from the daunting challenge of preparing for retirement. These two issues are so urgent and so omnipresent in our lives that it’s difficult to prioritize them rationally.
But as you can see, it’s actually quite simple to optimize your money usage so you can get out of debt and ready for retirement as fast as possible.
All you need to answer the age-old “paying off debt or investing” question is a basic understanding of opportunity cost and some simple arithmetic.
Until next time,
Samuel Taube
Samuel Taube brings years of experience researching ETFs, cryptocurrencies, muni bonds, value stocks, and more to Wealth Daily. He has been writing for investment newsletters since 2013 and has penned articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investment approach focuses on finding undervalued assets at every point in the business cycle and then reaping big returns when they recover. To learn more about Samuel, click here.
