Is it Better to Pay Off Debt or Invest?

Is It Better to Pay Off Debt or Invest?

Before deciding whether to focus on debt or investing, you need to understand your complete financial picture. This involves reviewing your budget, comparing interest rates and ensuring you have basic financial protections in place.

Review Your Budget First

Start by creating a budget if you don't already have one. A budget shows exactly how your monthly income is being used and how much you can realistically put toward debt or investing.

If you're new to budgeting, consider the 50/30/20 budgeting approach as a starting point because of its simple setup:

• 50% toward necessities: Rent or mortgage, utilities, groceries, insurance and other essential expenses
• 30% toward discretionary spending: Entertainment, dining out, hobbies and other optional purchases
• 20% toward savings and debt payments: Emergency fund, retirement contributions and extra debt payments

This framework isn't one-size-fits-all. If you're carrying high-interest debt, you may need to reduce discretionary spending below 30% to free up more money for debt payments. Your situation and goals should determine the right balance for you.

Alternatively, you can research and compare other budgeting methods to find a better option for you.

Learn more: How to Budget for Fixed and Variable Expenses

Compare the Cost of Your Debt to Investment Returns

Once you know how much money you can set aside each month, compare what your debt is costing you against what you could potentially earn from investing.

Look at your debt's annual percentage rate (APR), and then compare it to realistic investment returns. Historically, the stock market has averaged around 10% annual returns over long periods, though individual years vary significantly and returns are never guaranteed. A return closer to 7% after inflation may be a more conservative estimate.

• When debt costs more than investing earns: If you're paying 17% APR on credit card debt but expect 7.5% returns from investing, paying off that debt gives you a guaranteed 17% return in the form of avoided interest. This almost always makes paying off the debt the better financial choice.
• When debt costs less than investing earns: If your only debt is a car loan at 3.5% APR, you'll likely come out ahead by investing your extra money rather than making additional loan payments because you're earning more from investments than you're paying in interest.

How to Pay Off Debt

Tackling debt effectively requires a clear strategy. Follow these steps to create a plan that works for your situation.

1. Check Your Credit Reports

Review your credit reports to see all your debts in one place. You can start by registering with Experian to get free access to your Experian credit report and FICO^® Score^Θ.

You're also entitled to free credit reports from all three major credit bureaus (Experian, TransUnion and Equifax) through AnnualCreditReport.com. Your credit report lists all your credit accounts, balances and payment history, giving you a complete picture of what you owe.

Learn more: Understanding Your Experian Credit Report

2. Decide How Much You Can Pay

Calculate how much money you can realistically put toward debt each month beyond minimum payments. Review your budget to find areas where you can reduce spending. Even an extra $50 or $100 per month can make a significant difference in how quickly you eliminate debt.

Learn more: Side Hustles That Can Help You Pay Off Debt

3. Choose a Debt Payoff Strategy

Select a debt repayment method that fits your personality and financial situation. Some of the most common options include:

• Debt avalanche: This method focuses on paying off debts with the highest interest rates first while making minimum payments on everything else. Once the highest-rate debt is paid off, you move to the next highest. The debt avalanche saves you the most money in interest over time, making it the most cost-effective approach.
• Debt snowball: With the debt snowball strategy, you pay off your smallest debt first, regardless of the interest rate, then move to the next smallest. The quick wins can provide psychological motivation that helps you stick with your plan. While you may pay more in interest compared to the avalanche method, the emotional boost can be valuable.
• Balance transfer card: A balance transfer credit card lets you move high-interest debt to a card with a 0% introductory APR period, typically lasting six to 21 months. You'll usually pay a balance transfer fee of 3% to 5% of the amount transferred. This approach works best if you can pay off the balance before the promotional period ends. Good to excellent credit is typically required for approval.
• Debt consolidation loan: A debt consolidation loan combines multiple debts into a single personal loan with one monthly payment. If you qualify for a lower interest rate than you're currently paying, consolidation can save money and simplify your payments. Personal loans typically have fixed rates and repayment terms of two to seven years.
• Debt management plan: If you're overwhelmed, a nonprofit credit counseling agency can help you set up a debt management plan. The agency negotiates with creditors to potentially lower interest rates and combines your debts into one monthly payment you make to the agency. This option typically takes three to five years to complete and may involve modest upfront and ongoing monthly fees.

Learn more: Reasons to Pay More Than the Minimum on Your Credit Card

4. Avoid Debt in the Future

As you pay down debt, it's important to develop habits to stay debt-free. Here are just a few things you can do:

• Create a budget that includes irregular expenses. Account for costs that don't occur monthly, such as car repairs, medical bills, annual insurance premiums or holiday spending. Setting aside money for these predictable-but-irregular expenses prevents you from relying on credit cards when they arise.
• Build a starter emergency fund. Begin by saving $500 to $1,000 for minor financial emergencies like a car repair or medical copay. This small cushion can prevent you from going back into debt when unexpected expenses occur. Once you have this starter fund, continue adding to it while you begin investing, working toward an emergency fund with three to six months of basic expenses over time.
• Pay credit card balances in full. If you use credit cards, pay the entire statement balance each month before the due date. This allows you to benefit from rewards and convenience without paying interest charges. Set up automatic payments or calendar reminders to avoid missing due dates.
• Track your spending regularly. Review your expenses weekly or monthly to ensure you're staying within budget. This awareness helps you catch potential problems early and adjust your spending before small issues become bigger financial setbacks.

Learn more: How to Get Out of Debt

How to Start Investing

Once you've addressed high-interest debt and built financial stability—or if you don't have any high-interest debt to pay off—you can begin investing for your future. Here are some steps to help you get started with the process:

1. Get your employer match. If your employer offers a 401(k) match, contribute at least enough to capture the full match. This is essentially free money and a guaranteed return of up to 100% on your investment. Even if you have debt, getting the full employer match should be a priority.
2. Open an investment account. Depending on your goals and time horizon, choose between a workplace retirement account like a 401(k) plan, an individual retirement account (IRA) or a taxable brokerage account. Retirement accounts offer tax advantages but restrict access to funds before retirement age. Brokerage accounts provide more flexibility but no tax benefits.
3. Start with low-cost index funds. For beginning investors, low-cost index funds or exchange-traded funds (ETFs) provide diversification without requiring you to pick individual stocks. These funds track market indexes like the S&P 500 and typically have lower fees than actively managed funds.
4. Automate your contributions. Set up automatic transfers from your checking account to your investment account. Consistent investing, even in small amounts, builds wealth over time through compound returns. You don't even need large sums to start, as some brokerages allow you to begin investing with as little as $1.
5. Increase contributions over time. As your income grows or you pay off debt, gradually increase how much you invest. Even boosting contributions by 1% of your salary annually can significantly impact your long-term wealth.

Tip: You don't have to choose investing or paying off debt exclusively. Many people benefit from a balanced approach that includes paying extra on high-interest debt while capturing an employer 401(k) match and building emergency savings.

Frequently Asked Questions

Find Your Balance

Deciding whether to pay off debt or invest requires looking at your complete financial picture. Focus on eliminating high-interest debt first, as it typically costs more than you can reliably earn through investing. Once you've tackled expensive debt and built an emergency fund, you can begin investing for long-term wealth.

As you work on improving your financial well-being, Experian's free credit monitoring tool lets you monitor your credit as you work toward your financial goals, helping you track your progress as you pay down debt and build wealth.