Pay Off Debt or Invest? Here’s the Best Way to Prioritize

Deciding what to do with your extra money can feel like a juggling act: Should I pay off debt or invest? While both options move you toward financial security, the best approach often depends on the type of debt you have and your overall money goals.

In most cases, the consensus is to focus on high-interest debt repayment first—especially if you’re dealing with credit cards or other high-interest loans—and then direct more funds into investments. Let’s walk through the key considerations to help you make a confident decision.

Pay Off Debt or Invest: The Big Dilemma

Defining the Problem

Many people find themselves torn between the desire to pay off debt quickly and the need to start building wealth through investing. Here’s why this problem comes up so frequently:

Limited Resources: Most of us don’t have unlimited funds, so every dollar directed toward debt is a dollar not invested—and vice versa.
Future Growth vs. Immediate Relief: Investing can lead to significant returns over the long term, but outstanding debt, especially at high interest rates, often grows faster than some investments yield.
Emotional Stress: Being in debt can be mentally taxing, yet missing out on compounding interest can also weigh heavily. Balancing both feelings is part of the challenge.

The Risks of Ignoring High-Interest Debt

One key risk of waiting too long to address high-interest debt is the cost of accumulating interest. For example, credit card rates can easily range from 15% to 25% or more:

Escalating Monthly Balances: Even small debts can balloon if you’re being charged high rates.
Damage to Your Credit Score: Higher balances relative to credit limits can lower your credit score.
Opportunity Cost: Money spent on interest is money that can’t be invested, used for an emergency fund, or saved for other goals.

In short, high-interest debt is like an anchor that keeps you from moving forward financially. It’s usually the first place to focus.

Prioritizing High-Interest Debt

How to Identify High-Interest Loans

Identifying high-interest debt is essential for effective management. As a general rule:

Credit Card Balances: Rates commonly hover above 15%, and anything over 10% deserves priority.
Payday or Personal Loans: These can come with extremely high rates, sometimes over 30%.
Private Student Loans: While not always “high,” they can reach double digits depending on your credit history.

Gather all of your debt accounts, list their interest rates, and focus on repaying the highest ones first. This approach, often called the debt avalanche method, minimizes the total amount of interest you’ll pay.

Emotional Benefits of Becoming Debt-Free

Beyond the numbers, paying off debt often yields emotional rewards:

Reduced Stress: Constantly worrying about bills and interest charges can take a mental toll.
Increased Confidence: Achieving a debt-free milestone brings a sense of empowerment.
Greater Flexibility: Without debt payments, you have more cash flow to direct toward investing or other goals.

Investing Basics: When and How to Start

Building a Strong Financial Foundation

Before diving into the stock market or other investments, establish a solid foundation:

Emergency Fund: Aim for three to six months’ worth of living expenses in a savings account for easy access.
Insurance Coverage: Health, life, and disability insurance protect you and your family from unexpected events that could derail your finances.

Having these basics in place allows you to invest more confidently for the long term.

Where to Invest First

Not all investment accounts are created equal. Some are better starting points than others due to tax benefits and potential employer contributions:

Employer-Sponsored Retirement Plans (e.g., 401(k)): If your employer offers a match, contribute at least enough to capture that “free money.”
Individual Retirement Accounts (IRAs): Traditional IRAs and Roth IRAs both offer tax advantages. Depending on your income, you might qualify for an immediate tax deduction (Traditional IRA) or tax-free withdrawals in retirement (Roth IRA).
Brokerage Accounts: If you still have funds after maximizing contributions to tax-advantaged accounts, you can invest in a standard brokerage account for greater flexibility.

Source: Citizens

Combining Strategies for Optimal Results

Splitting Your Extra Income

If you have moderately low-interest debt or a valuable employer match, a hybrid strategy might be best:

Allocate a Portion to Debt: Pay the minimum on all debts, then add extra to high-interest balances.
Invest the Remainder: Contribute enough to your 401(k) or IRA to get the employer match or capitalize on market growth opportunities.

This way, you’re not missing out on investment perks while still addressing your most expensive debts.

Monitoring Your Progress

Financial goals aren’t static. Keep track of your debt repayment and investments:

Use Budgeting Tools: Apps or spreadsheets can help you track monthly expenses, balances, and contributions.
Check Investment Performance: Periodically reassess your portfolio to ensure it aligns with your risk tolerance and goals.

If you notice changes in your finances—like a raise, a new expense, or shifting priorities—adjust your strategy accordingly.

Making the Decision: A Step-by-Step Guide

Calculating Your Interest Rates and Returns

To decide whether to pay off debt or invest, compare your interest rates and expected returns:

List All Debts: Record the APR and outstanding balances.
Estimate Potential Investment Returns: Historically, the stock market yields around 7%–10% annually before inflation, though returns vary.
Compare the Two Figures: If your debt’s APR is substantially higher than your potential investment gains, prioritize paying off that debt. If it’s relatively low (e.g., under 5%), consider allocating more money to investments.

Rebalancing Over Time

Financial circumstances and markets change. Stay on track by:

Re-evaluating Your Debt
- Have interest rates changed? Can you refinance?
Assessing Your Investments
- Markets fluctuate. Review your portfolio periodically.
Updating Your Goals
- Major life events like marriage, having children, or career changes can shift your debt or investment priorities.

Paying off high-interest debt first, then maximizing your investments, is a reliable strategy for most. Revisit and rebalance as needed to keep everything aligned with your evolving life.

Answering The Question

So, should you pay off debt or invest? The short answer is to tackle high-interest debt first. High interest rates can quickly outpace what you’d typically earn in investments, making it a priority for your financial well-being. After that, you can take full advantage of compounding returns on your investments.

Step 1: Identify and prioritize high-interest debt.
Step 2: Build an emergency fund and secure insurance coverage.
Step 3: Invest in tax-advantaged accounts, especially when you can benefit from an employer match.
Step 4: Reassess and rebalance as your situation changes.

By following these steps—and keeping an eye on your shifting financial picture—you’ll strike the right balance between eliminating debt and building a healthy investment portfolio. This balanced approach sets the foundation for a more secure and prosperous financial future.