One of the first big decisions you’ll need to tackle as you take an active role in improving your financial situation is whether you should focus on investing versus debt payoff. This question stressed me out for the longest time! I worried about making the right decision, when in reality both moves can get you where you want to go. Your best bet? Choose the path that feels right and just get started. You can always make course corrections along the way.
Unsure how to choose? Answer the five questions below to determine the best course of action for you.
What is your risk tolerance?
Only you can answer this question. Risk tolerance varies greatly by person and life stage. Your age, income, and time horizon should all be taken into consideration. The further away you are from needing access to your money, the more risk you can safely take and the more you can benefit from compounding interest. If you’re close to retirement, it usually makes sense to pay down debt. If retirement is decades away, you may be better off investing any extra cash.
What does your monthly cash flow look like?
It’s important to evaluate your cash flow. Are things tight at the end of the month? Are your debt payments manageable? Decreasing debts can provide peace of mind. In our case, our graduate student loan payments were high. Consolidating the loans was an option, but we chose not to consolidate in order to pay off the smaller ones quickly to bring down our overall monthly payment. The minimum monthly payment is much less scary now that we’ve paid off a few loans. On the other hand, if your debt payments are a small percent of your monthly income and the interest rate is reasonable, you may come out ahead by putting extra funds into low fee index funds instead.
What are your investment options?
Most people compare interest rates. However, it’s best to evaluate your options by comparing the after-tax return on money invested to your after-tax cost of debt. Your interest rate is only part of the equation—the true cost to you may be lower if you can deduct your mortgage interest payments or student loan interest payments come tax time. If the idea of figuring this all out on your own is overwhelming, consider working with a certified financial planner to come up with an action plan. You likely won’t need ongoing advice, but paying a professional to help you choose a path when you’re overwhelmed can be a great investment.
Could you invest and pay down debt at the same time?
Investing and paying down debt are often presented as an either/or choice, but It’s okay to do both. Many experts recommend switching between goals as you build a strong foundation. Consider putting enough into your retirement accounts each year to qualify for the full employer match first, paying off any credit card debt second, and building a small emergency fund third. Each step improves your financial position, as you switch your focus between investing and debt payments. Once those first steps are handled you can move on to paying off any consumer debt, maxing out your retirement fund contributions for the year, opening a low fee index fund account, or making extra mortgage payments. The order can vary depending on your risk tolerance and cash flow.
Could you tackle an easy win up front?
Do you have a small debt you could pay off quickly if you put your mind to it? Acknowledging the easy wins along the path to financial independence can help you stay the course. Any time we felt stuck, paying off a small student loan helped us see our progress and regain momentum. It can also help to track your debt total monthly, so you can look back and see how far you’ve come whenever you feel discouraged.
Whichever path you choose, congratulations! Either course deserves celebration and is an investment in your future wellbeing. I love that paying down debt reduces money stress and provides a sense of increased flexibility. In our case, investing has yet to be our main focus, but at a minimum we know that the money we’re contributing to our 401ks will provide greater security in retirement.
How do you balance investing versus debt payoff? Do you believe in focusing on one or the other, or do you balance the two?