Should I Invest While Paying Off Debt?

Here's a question we get quite often:

"I get pretty good cash gifts over the holidays - should I use it to invest or to pay off debt?"

...As always, it depends: there are several things to keep in mind.

Try to pay down your high-interest debt first

Generally speaking, it’s smart to pay off your high-interest debt (like credit card debt) before investing, because you will likely have to pay more in interest on average than you will make from your investments. For debts that charge an APR of 12%+ a year, it’s risky to try to find an investment that returns as high of a percentage.

The rule of thumb is this: invest if the expected rate of return is higher than the interest rate of the debt.

For example, assume you have a student loan that charges you 5% per year. Simultaneously, Apple (AAPL) is expected to grow 10% this year. If you paid down your $2500 worth of debt, you would be charged $125 less in interest (a net gain of $125). However, if you $2500 invested in Apple, you would have gained $250 instead. Thus, you should invest in Apple, as you would gain more money. Unfortunately, life is rarely that simple. It’s difficult to measure how much you will make from an investment. There’s always a risk that you lose money from investing, so the chance and scale of that loss should always be considered when choosing between investing and paying down your debt.

All this being said, sending all of your leftover cash* towards debt payoff may have its own consequences - the second an unexpected expense pops up, you may not have anything set aside to cover it besides credit cards, setting you back in your debt freedom journey. Starting to save and invest means a longer debt freedom journey, but a less bumpy one. Now the question is, how much to invest?

*What is leftover cash? Leftover cash = income - expenses/bills - minimum debt payments. For example, if my monthly income is $4k, expenses/bills are $2.5k, and min debt payments are $500, that leaves $1k of leftover cash to play with.

How much to invest

Before you think about investing, ask yourself,

1. Do I have any cash saved up in case of an emergency?

If you don’t have any cash saved up, we would recommend starting to save in a high-yield savings account first (HYSA). They typically yield 0.5% APY+ and are basically risk-free as they are FDIC-insured (i.e. the government will pay you back if it’s lost). For the best HYSA accounts check out Nerdwallet. Building up an emergency fund or cushion (3-6 months worth of post-tax income) should be any debtors first priority before moving on to more sophisticated cash allocation strategies. We recommend setting aside around 20%-30% of your leftover cash towards saving while sending the rest towards your debt.

2. What is my risk appetite? Am I willing to lose for a potential high return, or am I risk-averse?

Let’s say you have started building up a cushion and are willing to take some risks. We would still recommend continuing to put capital into risk-free vehicles (like HYSAs), but perhaps rather than putting 20-30% towards only savings, you can think about splitting it half and half or even more with investing (e.g. 15% to saving, 15% to investing, while the remaining 70% still goes to debt payoff).

3. How much time am I willing to set aside to invest?

For folks who want to invest but don’t know where to start, using an auto-investing app may be the best route. Acorns is a great option as it rounds up your purchases to the nearest dollar and automatically invests it in a strategy that fits your risk profile. Other investing auto-pilot apps include:

• ‍Stash
• ‍Wealthfront
• ‍Betterment
  

Paying down debt is your safest investment

Think of paying your debt as an investment - the interest rate of your debt is the rate at which you lose money. The amount of money you lose is reduced by paying down debt faster, so you essentially guarantee to limit your losses by focusing on debt paydown.

On the other hand, investing has the potential for outsized returns. However, a bad investment can quickly go sour and seriously jeopardize your financial wellbeing. We believe continuing to pay down debt is your safest route to debt freedom, while setting aside 15-30% of your leftover cash first to saving, and then to investing, will help you grow your wealth for the long term.

Tl;dr

In summary, follow these steps:

1. Calculate your leftover cash after expenses, bills, and minimum debt payments
2. Send 70-80% of your leftover cash towards high-interest debts
3. Break up the remaining 20-30% between saving and investing. If you don’t yet have an emergency savings fund, do all of it in savings. If you have at least 1-2 months worth, start investing
4. Try out some auto-pilot investing apps before doing more self-directed investing.
5. If you have low-interest debts, we recommend paying the monthly payment and focusing on investing in ETFs/index funds and growing along with the market.

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