There are a lot of questions in personal finance but maybe the biggest is invest or pay off debt? That is the question today.
This is the question we get at LMM most often. What should I do first, invest or pay off debt? Today Andrew has done the math.
There is a lot of emotions involved when it comes to making financial decisions but this framework largely removes emotion. This is straight up what you should do to optimize your finances.
This framework has to be applied to each debt individually, you don’t average out your debts and then follow the guidelines. One debt, one rule.
And the most important part of any debt repayment plan is focus. You can’t use a scattershot method and effectively pay off debt. Concentrate on one debt at a time. You can use the snowball or stack method, we went in-depth on both. TLDR; stacking saves the most money.
Once the debts (at least the high interest ones) are done and dusted, you need to apply the same focus to investing. Debt seems to concentrate the mind and our efforts in a way that investing doesn’t because debt is an emergency and we react to it as such. But investing deserves the same kind of focus so don’t neglect it.
The Framework: If This, Than That
If Initial Debt Interest is Above 10%
If you have a debt with an interest rate over 10% (usually credit card debt) it makes sense to try to refinance that debt. Even getting a new interest rate that is 1% point lower can save you hundreds or even thousands of dollars over the life of the debt.
There are a few ways you can do this. If the debt is on credit cards, look into a balance transfer. You open a new credit card that has an introductory period with 0% APR. The length of the introductory period varies but you can find some cards offering as many as 21 months.
You transfer the balance from the old card or cards to the new card. Now instead of paying mostly interest, you are only paying on the principle.
The catch is, you must pay off the entire balance before the 0% APR period runs out.
If you don’t, the remaining balance is subject to the new interest rate which may be higher than what you were paying on the old card.
You can also apply for a personal loan through a bank or a peer to peer lender like Lending Club. You still owe money to a creditor but at a lower interest rate. Be aware of the fees involved, they may actually mean that you’re paying more overall even if the interest rate is lower.
If initial debt interest is between 7% and 10% refinancing is your best option for debt interest in this range too, again be aware of any fees involved to refinance.
If You Have $0 in Your Checking Account
The first thing you need to do is to calculate your monthly expenses and multiply that number by 1.5. This is the minimum amount you should always have in your checking account. This is not spending money nor is it an emergency fund. This money is merely a safety buffer.
What constitutes monthly expenses? Add up the minimum payments on all of your debts, your fixed monthly expenses like rent or mortgage, utilities, and car payment.
Now, look at your variable monthly expenses, things like groceries, entertainment expenses, clothes, for the last couple of months. Add the lowest of each of those expenses. If one month you spent $400 on groceries and another month you spent $250, use $250.
You have your monthly expense number, multiply it by 1.5 and add another $500 to the number, just for peace of mind. This amount of money should never be spent. If your monthly expenses increase, recalculate your numbers and increase this buffer to the new amount.
If Post-Refinance Debt Interest Rate is Still Above 7%
You did well by refinancing but you’re still above 7%. An interest rate above 7% is high and your entire focus must be on crushing your debt because it is really draining on any effort to achieve financial independence.
Every extra dollar, from raises, bonuses, side hustles, gifts, must go toward this debt. The only investing you should be doing is putting enough money into your 401k in order to get the match because that is free money.
If Post-Refinance Debt Term or Completion is at 5 years or Less
What you need to do here depends on the interest rate. You aren’t too far away from killing this debt but you may need to get there faster.
If you have five years left on something like a student loan, mortgage, put 100% of excess cash into paying this off. You’re this close to a good spread between paying off debt and investing at 2% (with an average respected return of 7%) but you can’t predict market returns and in such a small time horizon, your risk goes up.
If your interest rate is between 3% and 5% you have some wiggle room here. At this point, you can use your personal tolerance for risk to make your decision. If you are a low-risk person, pay off the debt. If you believe in every life a little risk must fall, you can start investing.
If your interest rate below 3% invest. You now have a 4% spread over the long term.
If Post-Refinance Debt Term or Completion is More Than 5 Years
If your interest rate is below 4% invest, your return will almost certainly outpace inflation and inflation will nearly wipe out the actual cost of your debt.
If your interest rate is between 4% and 7% follow base financial theory: If your after-tax return on investments is greater than your after-tax cost of debt then you should invest. https://www.calcxml.com/calculators/pay-off-debt-or-invest
The list of the calculation is that the highest interest rate gets focused first, however, interest rates are adjusted based on tax benefits. Tax deductible interest (mortgage, student loans) equally pair against investments where the return is not taxed.
Debt, Emergency Funds, and Investing
We have tons of material on both subjects.
As you can see, all debt is not the same. The worst kind of debt is credit card debt because the interest rate is so high, just over 15% on average. This debt needs to be tackled ASAP and you need a plan to do it. You can use the snowball or stack method. Choose one and focus like a laser on getting rid of this debt.
If you want to make some extra money to pay that debt down even faster (you do) you can check out some ways to make extra money.
Student loan debt is less of an emergency than a credit card because the interest rates are lower. If you have private student loans rather than federal though, you may have a fairly high interest rate. You can use these tips to pay it down faster and look into refinancing with Earnest.
I put emergency funds between debt and investing because that’s where it falls in the hierarchy of personal finance priorities.
High-interest debt should be your priority but even then, having $1,000 for something like a car repair or an emergency room co-pay can give you some peace of mind and prevent you from reaching for the credit cards.
Once you are out of debt, or at least out of high-interest debt, you want to increase your emergency fund to somewhere between three and six months worth of monthly expenses. We’ve already talked about how to come up with the number for your monthly expenses, you use the same method here.
There is no way to achieve financial independence or even a moderately comfortable retirement unless you are investing, ideally early and often. If you’re afraid to get started, start with Betterment. You don’t have to know anything, there is no minimum, and the fees are very low. Andrew wrote a whole guide to using Betterment.
Even if you aren’t making a ton of money, you can still invest and grow your wealth. We show you ways to invest on a small income.
Part of your investing strategy has to generate passive income for you. There are only so many hours a day we can work so we need to have money coming in when we’re doing things that are more fun like vacationing or sleeping.
If you want to get into real estate without owning rental property you can still invest with a company like Fundrise.
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Run the Numbers
Humans don’t operate in a vacuum but numbers do. If you still don’t feel sure, we’ve included some tools so you can run your individual numbers and see for yourself if it’s better to pay off debt or invest.
Pay Off vs Hold Excel Spreadsheet (found in the bowels of the internet)
Even More Jesus Evil Twin Brewing: An Imperial Stout.
Sour Monkey: A sour ale from Victory Brewing Company.
Investable: Research and evaluate rental properties.
Tool Box: All the best stuff to manage your money.