Ugh, monthly debt payments, am I right?
Air that grievance to almost anyone, and you’ll find a sympathetic ear — 77% of Americans carry debt, after all. Whether the balance is from student loans, credit cards, a car loan, or another type of personal loan, those interest rates can hurt.
So once you feel motivated to ditch your debt, it’s easy to think that you should throw every spare penny you have at it. But on the other hand, there’s the cost of waiting to invest.
But wait … so what is the actual best thing to do with your spare pennies: pay off debt or invest?
The answer is one of my favorites as a CFP® Professional: It depends.
When to invest and when to pay off debt instead
Here’s what we usually recommend:
First: Each month, aim to put something toward Future You — ideally 20% (or more, if you can swing it) of your take-home pay, but whatever you can do is great to start. That would include debt payments above the minimums, saving, and / or investing. Pro tip: Build this into your budget, which is one component of your financial wellness plan.
Once you have that “Future You” amount set, there’s an order in which we typically suggest spending that part of your budget. Start by saving up one month’s worth of take-home pay in a FDIC-insured bank account (or NCUA-insured credit union account). This “mini-emergency fund” will be the beginning of your larger emergency fund, and will give you peace of mind while you move onto your high-interest debt.
With your mini-fund squared away, then you can start putting that monthly Future You budget toward any debt with interest rates above 10% — usually credit cards, but this can also apply to higher-interest loans.
Finally, with those nastier balances out of the way, it’s time to turn that Future You paper back toward your emergency fund, until you have roughly three to six months’ worth of take-home pay. (Don’t stop paying the minimum payments on any lower-interest rate debts, though. Missing minimums can wreak serious havoc on your credit report.)
Then: When you only have debts with interest rates of less than 10% and have built up your emergency cushion, turn your entire focus to debts between 5–10% — and then investing.
Why not pay those lower-interest debts off, too? So glad you asked.
It’s all about interest rates
Credit card debt hurts: Those shiny pieces of plastic can come with interest rates of 14% to 24.99%. On the other hand, some federal student loans’ interest rates can be as low as 3% to 4%. So that’s a pretty big range.
As for investing returns, that’s historically fallen somewhere in the middle. Part of the reason waiting to invest could cost you so much is that over the last 94 years, the stock market has had a long-term positive return — an annual average of 10%. (Some years it’s more, some years it’s less, and some years it’s negative, but that’s the historical trend over the long term.)
This is what the debt-vs-investing decision is all about. You want to focus on paying off debt if it’s likely to cost you more in interest than you might otherwise earn through investing. And you want to focus on investing if you think it’s likely to earn you more than you’d otherwise pay in interest.
At Ellevest, we believe that a reasonable, conservative benchmark to draw the line between these two is around 5%. So that’s why we usually recommend that if the interest rate is more than 5%, pay it off. If it’s less, stick to the minimum payments and invest the extra instead.
Still, there’s a little bit of gray area
We know that it can be a bit scary for some people to wait until all their debt above 5% is gone to build up their emergency savings. And that’s totally reasonable — financial emergencies happen. And it’s especially reasonable if you rely on a less-than-stable source of income, like freelance or small business earnings.
So, if you’re itching to build up that savings ASAP, here’s my advice. Anything with an interest rate of more than 10%? That’s black and white. Pay it off ASAP, and wait to build your emergency fund.
But for debt with interest rates between 5% and 10%, that’s a little bit more gray. In that case, you might split your “Future You” money between paying off the high-interest debt and building up your emergency fund, or paying off debt and investing. Going that route is a personal choice — feel free to do what seems best for you and your financial situation.
At the end of the day, any money you’re putting toward debt or investing is a step in the right direction. So let the math tell you which one to focus on first … and know you’re doing Future You a favor.
Source Ellevest. To calculate “$100,” we compared the wealth outcomes for a woman who begins investing at age 30 with one who began investing at age 40 after having saved in a bank for 10 years. Both women begin with an $85,000 salary at age 30 and all salaries were projected using a women-specific salary curve from Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc., which includes the impact of inflation. We assume savings of 20% of salary each year. The bank savings account assumes an average annual yield of 1% and a 22% tax rate on the interest earned, with no account fees. The investment account assumes an investment with Ellevest using a low-cost diversified portfolio of ETFs beginning at 91% equity and gradually becoming more conservative during the last 20 years, settling at 56% equity by the end of the 50-year horizon. These results are determined using a Monte Carlo simulation—a forward-looking, computer-based calculation in which we run portfolios and savings rates through hundreds of different economic scenarios to determine a range of possible outcomes. The results reflect a 70% likelihood of achieving the amounts shown or better, and include the impact of Ellevest fees, inflation, and taxes on interest, dividends, and realized capital gains. We divided the calculated cost of waiting 10 years to invest, $341,181, by 3,650 (the number of days in 10 years). The resulting cost per day is about $93.47.
The results presented are hypothetical, and do not reflect actual investment results, the performance of any Ellevest product, or any account of any Ellevest client, which may vary materially from the results portrayed for various reasons.
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