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 be rough.

Once you feel motivated to pay off debt, it’s easy to think that you can’t invest yet and instead, should throw every spare penny you have at it. On the other hand, there’s the cost of waiting to invest (thanks to the power of compounding).

But wait … so what is the actual best thing to do with your spare cash: pay off debt or invest?

The answer is one of my favorites as a CFP® professional: It depends.

How to decide when to pay off debt or invest

Before you make any decisions, we recommend that you make a habit of basic budgeting. Each month, aim to put at least 20% of your take-home pay toward Future You. This will go toward three things: saving, investing, and paying off debt above the minimums. If you have a lot of debt or big financial goals, and you can swing it, aim for more than 20%. Now, using that slice of your budget, follow this order:

1. Invest: Take advantage of your employer’s 401(k) match

Maxing out the most commonly offered 401(k) employer match (50% up to 6%) is like getting an instant 50% return on your money every paycheck. No matter how much debt you have, this is a money move that’s too good to pass up. Don’t have an employer 401(k)? Start with our next step. 

2. Save: Stash away one month’s worth of take-home pay

Start your emergency fund by saving one whole month’s worth of take-home pay. Because if something urgent pops up or unexpected goes down, it’s better to use that cash buffer instead of a credit card. 

3. Pay off debt: Clear away debt with interest rates above 10%

These high-interest debts are sabotaging your best budgeting efforts. Get ‘em paid ASAP — two popular debt payoff strategies should help. (Don’t stop paying the minimum payments on any lower-interest rate debts, though. Missing minimums can wreak serious havoc on your credit report.)

4. Save: Finish your emergency fund 

Shoot for three to six months’ worth of take-home pay (or up to nine months' worth if you’re self-employed).

5. Pay off debt: Knock out debt with interest rates between 5-10%

Now that you’ve ditched your spiciest debt, it’s time to focus on ones with interest rates between 5% and 10%. These aren’t hurting your bottom line as much, but they’re still worth tackling sooner than later. Have loans with interest rates less than 5%? Keep paying their minimums, but use the rest of your budget to … 

6. Invest: Go after your goals

Looking to build wealth? Buy a home? Start a business? You’ve got the green light to start investing toward your goals once the only debt left has interest rates of less than 5%.

Why not pay those debts off, too? So glad you asked.

Interest rates determine when to pay off debt or invest

Credit card debt hurts: Those shiny pieces of plastic can come with average interest rates of 24.06%. On the other hand, some federal student loans’ interest rates can be 4.99% to 7.54%.

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 90 or so years, the stock market has had a long-term positive return — an annual average of 9.5%. (Some years it’s more, some years it’s less, and some year’s it’s negative, but that’s the historical trend over the long term.) 

This is what the decision to pay off debt or invest is all about. You want to pay 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%. That’s why we usually recommend you pay off debt if the interest rate is more than 5%. If it’s less, stick to the minimum payments and invest the extra instead.

At the end of the day, any money you’re using to pay off debt or invest 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.

Want more personalized help with your financial priorities? An Ellevest financial planner can meet you where you are. Connect with us today.   

Disclosures