The decision to pay off debt or save and invest money is a common dilemma. The best solution largely depends on the type of debt you are dealing with and the interest rate that you are paying. Not all debt is created equal; high interest rate, non-deductible debt, like credit card debt and consumer financing, is generally a bad use of debt. On the other hand, low interest, tax deductible debt such as a mortgage or a home equity loan is generally a more favorable use of debt. Financially, it’s usually wise to own your home and few of us can afford to pay cash.
If you have a lot of consumer debt or a large credit card balance with a high interest rate, you are probably spending a substantial sum just to cover the interest. You need to pay more than your minimum payment to start working down the debt. It’s important to pay down debt, but you also need to maintain some liquidity to cover unexpected expenses. There is no magic formula for how much of your available cash should be used to pay down debt and how much should go toward building your emergency fund. Everyone needs an emergency fund, and I generally I recommend maintaining an emergency fund equal to about four months of expenses. However, if you are drowning in credit card debt consider using half of your money to pay down debt and the other half to build up an emergency fund until you have around $2,000. Continue along this path a while longer, if you want to build a larger emergency fund.
Without an emergency fund you could fall into a never ending debt spiral. If you don’t have an emergency fund, you may be forced to run up credit card debt again when the inevitable emergency arises.
As you make progress toward paying off debt, you may wonder if you should invest some money for retirement or your other financial goals. Generally, you should prioritize paying down debt if the after tax interest rate on your debt is higher than your expected after tax investment return. When considering the possibility of investing some of your funds, factor in the risk associated with investing your money. Investing is subject to fluctuations in the market, but there is no market risk associated with the interest you save by paying down debt.
Additional factors that may enter into the decision to invest some of your money include the opportunity to get an employer match on a 401k contribution and the potential tax deduction you could receive from contributing to a retirement plan.
Finally, if you pay down your high interest debt and you want to pay your mortgage off early, consider the impact this could have on your tax deductions. You also need to weigh this against the return you could earn, if the money is invested.