First of all, let me say that if you are a holder of school debt or credit card debt, my sincerest apologies go out to you. You see, I’ve had both of these types of debt. At one point, I had racked up $12K of credit card debt by eating out way too much. And then much later on in my career I decided to get a fancy Masters degree from a private university that set me back $40,000. Student debt for millennials is a killer, especially if you received a degree in underwater basket weaving that can’t get you a high paying job.. But that is a whole different discussion for another day (or rather, article).
But this brings us to an important question. Should you use your income and savings to pay off debt, or invest it instead? Like most questions in life, it depends…
Let’s look at credit card debt by itself. Credit cards these days charge at least 15% interest rate but usually are in the 20-something percent range. And if you miss a payment, the interest goes to an even higher rate. You would have to make a return greater than 15% to make sense for you to invest. This is nearly impossible. You won’t find any investment that gives you 15% to 20% a year.
Student loans are usually in the tens of thousands and are usually around 5%. As holders of school debt know it is very difficult to get rid of student loans via bankruptcy. Remember, filing for bankruptcy destroys your credit score. If you don’t pay your loan within 9 months, the government has the power to garnish your wages and intercept any tax returns that were coming your way.
So the question is what is the best use of your money: Which debt should you pay off first? Should you invest? Theoretically speaking, if your return is higher than your interest rate it makes sense to invest the money. But if your interest rate is higher, then pay off the debt. This is a simplified answer and doesn’t apply to every person. If you pay off the debt then the monthly payment you were making will cease. In a way, that is money back into your bank account. You can put that monthly amount into investing.
I am a single track mind guy and so that means I like to focus on one task and do it really well. I would target the highest interest rate debt and pay it off aggressively. You still want to make minimum payments on the other debts because you know what happens to your credit score when you don’t. I would also pause any IRA or 401k contributions temporarily and divert that money towards the debt.
If you have enough savings to get rid of the debt then please do so. Whatever you pay off is money back in your pocket immediately. If you have $150/month of credit card debt, and $400/month of school debt (like I did), that’s $550/month you can put back into your savings, or even invest it. Paying off debt also brings freedom, motivation and a peace of mind which should never be underestimated. It’s like you have a fresh start.
I am hoping that you have an emergency fund stashed away in case you lose your job or something disastrous happens. It would be wise to build this fund up especially if you are holding debt with low interest rate. Once you have a few months of emergency savings, you can aggressively start allocating money to pay off the toxic school or credit card debt.
Paying off debt is really about choosing a philosophy as much as it is about math and interest rates. For most of us, retirement is really far away, so it doesn’t make sense to pump money into your IRA or 401K if you are sitting on credit card debt at 24% APR.
So just a recap: Assess your situation. There are no rights and wrongs. High interest rate debt needs to be paid off, lower interest rate can be held longer. If you are holding a big amount of debt that is high in interest then you want to tackle this immediately. If you have a lump sum of cash to pay off the loan, then do so, as interest is always accruing. You can temporarily put a hold on retirement investing and aggressively pay off the loan with the highest interest rate.
Paying back debt is a numbers game as much as it is a philosophical game. Figure out the balance that works for you.