Should I Pay Off Debt Before I Invest?

Lets start with a question. Is all debt the same? You have probably heard of notable financial figures such as Dave Ramsey saying that all debt is bad and that you should avoid it at all costs. On the other hand, people like Robert Kiyosaki (author of Rich Dad, Poor Dad) advocate to learn how to use debt to make money.

Which one is right? Well, the short answer is that it depends. Debt can be good for you or it can be bad for you. Most people say you are in debt any time you borrow money. However, is this really the best definition of debt?

In our opinion, no. A more accurate definition of debt is anything that you borrow money for in which the only way you can repay it is from money you have to earn. Now, this might sound confusing so lets look at an example to explain what we mean.

Say that you just bought a new car with a loan from the bank. Most people would say that you are in debt, but according to our definition of debt, you are not. Why is this exactly? If you want to get out of the "debt" of the car loan, you can simply sell the car.

In this example, you might run into the problem where the amount you can sell the car for won't cover the balance of the loan. However, since you do have the option to get rid of the debt by selling the car, the car loan is not true debt.

Lets look at another example to clear things up. Say that you used your credit card for unneccessary consumer purchases and ended up in credit card debt. The only way that you can get rid of this debt is from money you have yet to earn - such as money from your job. Based upon our definition above, this would qualify as true debt.

Examples of good debt

1) Mortgages: The reality is that very few people can pay cash for a home. A mortgage will allow you to get in on homeownership which does have some benefits. Keep in mind that you don't want to get a mortgage that you can't afford.

2) Business loans: If you are able to secure a business loan and use that money to create a successful business that produces cash flow for you, a business loan can be good debt. Keep in mind that starting a business is risky so you should have a plan if you want to take out a business loan.

Examples of bad debt

1) Credit card debt: Credit card debt can be detrimental for a few reasons. First, the interest on credit cards often exceeds 20% making credit card debt harder and harder to get out of the longer you have it. Second, credit card debt can impact your credit score which can hurt your ability to borrow money later when you need it.

2) High interest personal loans: Any sort of unnecessary consumer debt such as taking out high interest personal loans for a vacation is bad debt. If you take out these types of loans and are not able to pay them back, it can get you into a lot of trouble.

Examples of debt that can be good or bad

1) Car loans: For many people, a car is a daily neccessity. If you get a reasonable car with a loan amount that you can afford, a car loan is by no means a bad thing. However, if you get to large of a car loan where you struggle to keep up with the loan, it can end up being a burden.

2) Student loans: Taking out loans for higher education can make sense if you get a return on the education so that you are able to pay back the loans. However, if your education does not provide you the return to pay off your student loans, it can end up being a burden.

Why the definition of debt matters when you are considering to pay off debt or invest

The point we are making here is that some debt is good and some debt is bad. Having an understanding of what is true debt (using our definition above), as well as the interest rate on the debt, can help you decide if it makes more sense to pay off your debt or invest.

Lets look at a couple different approaches you can take when deciding if you should pay off debt or invest. We will also give you a bonus rule at the end that most financial experts ignore, so make sure to read till the end.

The most logical approach to paying off debt versus investing is to use simple math. In general, if your investments can earn more interest than the interest on your debt, you don't need to pay off that debt before you start investing.

For example, if you have a car loan that has an interest rate of 5%, but your investments can earn you 10%, it would not make sense to wait until you have the car paid off to start investing. However, if you have credit card debt with an interest rate of 20%, it would make more sense to get that paid off before investing since your investments can only earn you 10%.

The problem with this approach?

It can be hard to determine exactly what interest rate your investments will earn. The stock market has averaged around a 10% return, but over decades. In the short term, the stock market can lose value and even crash. This can lead to confusion on where your dollars should go first.

For this reason, some financial experts recommend using a set rule to determine where your dollars should go first. For example, some experts recommend using the rule of 6%. This rule states that you should focus on paying down debt if it has an interest rate greater than 6% before you invest additional dollars.

Although using a rule like this is a good place to start, it does not factor in the power of compound interest over long periods of time. For example, say that you had a car loan with a 6.5% interest rate. The rule of 6% would say that you should focus on paying this off before you invest.

However, if you were to invest at the same time as you paid off the car loan, you would allow those dollars to have more time to compound over time. For this reason, we recommend taking a look at what your investments could earn over the long haul.

Most equity (stock) investments can earn anywhere from 10% to 12% over the long haul. If the interest rate on your debt is less than this, it makes sense to invest as you pay off your debt. If the interest rate on your debt is higher than this, it makes more sense to pay down that debt before you invest.

The mathematical approach to paying off debt versus investing does not factor in some of the emotions that can come from being in debt. You could be an individual that hates debt. If you find yourself in debt, your emotional response could be to get out of the debt as fast as possible.

The problem with this approach?

Having an emotional response to getting out of debt can sometimes be useful if it will drive you to get out of high interest or bad debt. However, it can get to the point where you are so hyper fixated on getting out of debt that you actually end up hurting yourself because you are not focused on investing at all.

In general, our recommendation is to take a mathematical approach when deciding if you should pay off debt or invest. It will help you eliminate some of your emotions and make logical decisions.

If you can, you want to simultaneously invest as you are paying off your debt. This is especially true if your investments can earn more interest than your debt. However, it could be that you are in the position where you have lots of high interest debt.

In this case, it might not be feasible for you to both invest and pay off the high interest debt. That is ok. Focus on paying off the high interest debt first, and then start investing. If your high interest debt is daunting, you can consider debt consoldation methods to put yourself in the position to invest.

Most of the advice you will find related to paying off debt versus investing focuses on the interest you will save from paying off your debt. However, most advice does not focus on the interest you lost, or could have earned if you did not have debt.

This is why you need to repay yourself the interest you could have earned from investing if you did not have to pay off bad or high interest debt. Lets look at an example to clear up any confusion.

Say you had incurred $2,500 of credit card debt at an interest rate of 20%. You think that you can only earn 10% interest from investing, so it makes more sense for you to try to pay off the credit card debt first.

Over the next 6 months, you get the credit card debt paid off. Once the debt is gone, most people take that extra money and spend it on their lifestyle. This is not want you want to do. Instead, you want to repay yourself $2,500 with 10% interest. Essentially, you want to save $2,500 plus 10% interest.

Why is this? Remember that if you weren't in credit card debt, you could have earned 10% interest on $2,500 by investing. In this example, you could take the first 6 months of the year to pay off the credit card debt. You could then devote the next 6 months to repaying yourself the interest you lost out on. By the end of the year you would have both saved yourself interest, and repaid yourself the interest that you missed out on.

1) Set up a starter emergency fund: Before you start paying off debt or investing, you should set up a starter emergency fund. An emergency fund is a cash reserve that you set aside for any unexpected emergencies that might come up.

Having a starter emergency fund can prevent you from going into bad debt to cover the cost of an emergency. We recommend saving between $500 and $1,000 to get started. You can learn how to set up an emergency fund here.

2) Pay off high interest debt: Once you have a starter emergency fund set up, you can start aggressively paying off high interest debt. High interest debt is a broad term, but in general focus on paying off debt that has an interest rate greater than 10%.

3) Repay yourself interest you lost out on: Remember, if you did not have high interest debt that you needed to pay off, you could have invested those dollars. After your high interest debt is paid off, you need to repay yourself the money you could have earned from investing.

4) Start investing as you pay off low interest debt: Now you can start investing. Even if you have lower interest debt, you should start investing as you pay off that low interest debt. If you need help investing, you can check out our complete guide on how to invest for beginners here.

The bottom line is that you can use the interest rate on both your debt and investments to determine the first place you should send your dollars. Again, if you can afford to do both, then do both. Finally, if paying off debt is your best or only option, don't forget to repay yourself the interest that you could have earned from investing.