Note: This article is for educational purposes only. It should not be considered as investment or personal finance advice. Consult a professional financial advisor for investment considerations.
What makes more financial sense? Prioritizing debt payoff or investing? While investing at an early age is essential to take advantage of the compounding of interest that strategy may be difficult to deploy when your level of debt seems insurmountable. Whether to invest or reduce your debt level is relative to your personal situation.
Reasons to Prioritize Investments
The earlier you begin investing, the greater your return on compounded interest. As an example, an initial investment of $5,000 earning an 8% interest rate, compounded over 45 years, would result in an amount approximating $160,000. That is a significant return on investment from the $5,000 originally invested.
Most people invest in Individual Retirement Accounts or retirement plans such as 401(k) and 403(b) plans. The advantage of 401 and 403 plans is that most employers will provide a match contribution up to a certain amount. For instance, if the employer provides a 6% matching contribution the employer will match your contribution, up to 6% of your salary. These plans also have an annual maximum contribution amount.
Prioritizing investments over debt reduction is that the additional funds earned by investments will eventually allow you to pay off your debt with additional funds remaining for your retirement.
Reducing Debt First
When reducing debt, the interest paid on debt may be less than the interest compared to the interest earned on investments. Funds invested in a Certificate of Deposit earning 2%, will not offset the interest paid on a car loan that has a rate of 6%. However, if your average annual return on your investments is 10%, and you have a loan charging 4% interest, it is more beneficial to add to contribute funds to your investment portfolio than to pay off the loan prior to its maturity.
If your debt is high and you find yourself with numerous monthly payments, it can be frustrating to live on a tight budget. Even though your investments are flourishing, you may be limited in your daily spending as more of your funds are allocated towards investments and not debt reduction. You may decide to change your strategy and reduce or eliminate your debt to become financially stable.
The best course of action is to have a financial plan that allows for all debt to be reduced or eliminated and have funds allocated for investments purposes. Individuals should assess their long and short-term goals and create a plan. A financial advisor can assist in creating a plan that works for you.