How to Decide When to Pay Off Debt or Invest

Let’s face it: monthly debt payments can feel overwhelming, right? If you chat about it with anyone, chances are you’ll find someone who understands. Many of us carry debt, whether it’s from student loans, a car loan, or personal loans. The interest rates can vary greatly depending on when you took on the debt and what kind of debt it is, but one thing is for sure — those payments can sting!

When the motivation hits to tackle your debt, it’s easy to think you should use every extra dollar you have to pay it off. But hold on a second — there’s a balancing act at play here. Paying off debt is important, but so is saving for your future. So, what should you do with your extra cash — pay off debt or invest? As a Certified Financial Planner™ (CFP®) professional, I often say: it depends on your situation.

Before jumping in, we recommend that you review and understand all your monthly expenses and create an intentional spending plan (aka, a budget). Each month, aim to set aside at least 20% of your income toward three key areas: saving, investing, and paying off debt above the minimum payments. If you have significant debt or ambitious financial goals, consider saving even more than 20%. Here’s a step-by-step guide on how to allocate that portion of your budget:

1. Invest: Maximize Your 401(k) Match.
   If your employer offers a 401(k) match, take full advantage of it! It’s like getting an instant 50% return on your money with every paycheck — a smart move, no matter how much debt you have. Don’t have a 401(k)? That’s okay; let’s move on to the next step.
2. Save: Build a Cash Buffer.
   Start by saving one month’s worth of your take-home pay. This cash buffer can be a lifesaver if unexpected expenses pop up, allowing you to avoid relying on credit cards and increasing your debt.
3. Pay Off Debt: Focus on High-Interest Debt.
   Pay down any debt with interest rates above 10% first. These high-interest debts can really sabotage your financial goals, so it’s best to tackle them ASAP. Just remember to keep making the minimum payments on lower-interest debts in the meantime to protect your credit score.
4. Save More: Complete Your Emergency Fund.
   Aim for three to six months’ worth of take-home pay in your emergency fund. If you are self-employed, we recommend six to nine months’ worth.

At the end of the day, whether you choose to pay off debt or invest, every decision you make is a step toward a more secure financial future for you and your family. Remember, it’s all about balance. Use your hard-earned money wisely — paying off debt can free you from financial stress, while investing can help you build wealth for the years ahead.

Don’t forget to let the numbers guide you: if the interest on your debt is higher than what you might earn from investments, focus on paying that off first. If your debt is manageable and the interest rates are under 5%, it might be time to focus on investing instead.

You’ve made it this far; now it is time to take the steps to get started. Take a breath, trust the process, and know that you’re doing what’s best for your future self! After managing your debt, it will be time to create a comprehensive financial plan and see how investing more can support meeting your long-term objectives.

*All of Coldstream’s staff shall attain the required licenses and designations necessary for his/her position. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP® and Certified Financial Planner™ in the U.S.