Should You Invest Money in the Stock Market or Pay Off Debt?
Million dollar question: should you invest or pay off debt? This decision is a struggle for younger and older individuals alike.
Fret not. Here are the exact steps and calculations for you to decide whether to invest cash in the stock market or throw your money to get out of debt as quickly as possible. (hint: you can do both).
- Don’t invest until you have a 3-6 month emergency fund.
- Wait to invest until you have paid off high-interest debt like credit cards.
- Prioritize debt payoff with low-interest debt like student loans if interest is higher than 6% (but still invest the minimum in your employer’s 401K).
- Invest in the stock market if debt interest rate is lower than 6% (make the minimum payment or pay a little extra on your debt while investing)
Step 1: Ensure you have an emergency fund first.
Already have an emergency fund that covers at least 3-6 months worth of living expenses? Proceed to Step 2.
Before you can invest or pay off debt, you need a financial oxygen mask or an emergency fund to easily cover any emergencies thrown your way.
An emergency fund is a stash of money (typically in a savings account) that ensures you have accessible cash in case of an emergency.
The most common emergencies include major household repairs, car expenses, and medical emergencies.
Only 39% of Americans could cover a $1,000 emergency. It’s important to save and have cash on hand so you don’t have to borrow money (and go into more debt!).
Experts typically agree that you need at least 3-6 months worth of living expenses saved up to have a proper emergency fund. But this amount looks different for different people.
Here’s how to determine exactly how much you need to save (and how to break down saving goals per month).
- Decide whether you need three months or six months worth of living expenses. The right number for your emergency fund depends on your monthly expenses + your current living situation. For example, if you have a stable job and don’t expect your situation to change, a three-month emergency fund should be fine.
- Determine your monthly living expenses including housing, food, healthcare, transportation, personal expenses, and debt. Total the costs.
- Multiply the total by 3-6 months. Say that you have $2,000 in monthly living expenses. $2,000 x 6 months = $12,000 emergency fund.
- Calculate how long it will take you to save this amount. If you have $1,500 leftover every month after living expenses and you can reasonably save $1000 for your emergency fund, it will take you 12 months to save a $12,000 emergency fund.
Store your emergency fund where it’s easy, but not too easy to get to. If the money is sitting under your mattress or in your checking account, for example, you’re likely to spend it. At the same time, putting your money into something like a CD will make it much harder to access your savings.
We recommend opening a high-yield savings account (HYSA). An HYSA typically has no restrictions on accessing your money AND your money earns a little interest. Withdraw or deposit anytime you like. You also normally don’t have to worry about high fees or minimum balance requirements.
Open a HYSA that’s separate from your regular banking account. Say that you normally bank with Capital One. Your emergency fund HYSA savings account might be with Bank of America. Out of sight, out of mind, but the money is there when you need it.
Once you have an emergency fund, you’re ready to look at investing and debt payoff.
Step 2: Pay off high-interest debt first (aka credit cards).
The decision to invest or pay off debt ultimately comes down to your type of debt and interest rate. If you have high-interest debt, wait to invest and pay it off as quickly as you can.
Here’s why. The interest rates of high-interest debt (think credit cards, not student loans) typically range from 15-30%.
The higher this interest rate, the more your debt will grow AND the longer you’ll be in debt if you don’t make over the minimum payment. The money you pay in interest will be more than you’d make in the stock market.
Here’s an example. The average credit card interest rate or annual percentage rate is 16.22%. Let’s say that you’ve racked up $3,000 in credit card debt with a 16.22% interest rate. You’re making the minimum $120 payment per month.
At this rate, you’ll be in debt for 108 months (or nine years) and pay $1425 in interest.
Mark Cuban, Shark Tank investor and business guru correctly sums it up, “…recognize that the 18 percent or 20 percent or 30 percent you’re paying in credit card debt is going to cost you a lot more than you could ever earn anywhere else.”
Aggressively pay off high interest debt (typically with interest rates 15% and up) before investing and throw any extra money at the debt. You’ll save hundreds to thousands of dollars on interest.
Step 3: Balance paying off low-interest debt (aka student loans) with investing in the stock market.
You’ve built your emergency fund and paid off high-interest debt. Should you now invest in the stock market even if you have low-interest debt like student loans?
Absolutely. Why? Because money invested can grow faster than your low-interest debt.
Money in the stock market earns 6-8% in interest over time (and that’s being conservative). If your student loan debt has a 3-5% interest rate, the money you earn by investing will outweigh the amount of interest you’ll pay over time.
Here’s a good rule of thumb:
- Prioritize investing if your low-interest debt has an interest rate lower than 6%: Focus on investing (including in retirement accounts) and making minimum debt payments (or putting a little extra if you really want to get out of debt faster).
- Prioritize debt payoff if your low-interest debt has an interest rate higher than 6%: Maybe you have a mix of federal and private loans and interest rates are high. Private loan interest rates can also increase over time. In this case, focus on eliminating your debt, but still contribute to your company’s 401K.
for either option, always invest at least the very minimum in a 401K, especially if your company offers a 401K match (i.e. they’ll match the amount that you contribute). You can still invest in the stock market by choosing your 401K investments (aka index funds).
This practice helps you take advantage of compound interest – your best friend in the stock market – even while climbing out of debt. Compound interest means that, not only does your initial investment earn interest, but your interest earns interest (normally earned monthly or annually).
Compound interest makes your money work harder for you and, over time, it can literally make you a millionaire.
Say you’re 25 years old and you start investing $500 per month in a retirement account while also paying off your student loan debt. At a 7% return rate, you’ll have over $1.2 million in 40 years by investing.
Now say that you wait five years. You prioritize paying off your student loan debt before investing $500 per month. You’ll have almost $861K in 35 years – or $340,000 less than what you would have if you’d started investing earlier.
Invest in a retirement account as early as possible to take advantage of compound interest. If you put this step on hold until your loans are paid off, you’ll have to save so much more later on in life to comfortably retire.
Invest or pay off debt? Both are good.
The decision to pay off debt or invest shouldn’t be an either-or-scenario.
While it does depend on your personal situation (aka why it’s called personal finance), investing while you pay off debt ensures you don’t put off building up wealth.
Here’s an easy checklist for determining when to invest and pay off debt:
- Build a 3-6 month emergency fund.
- Pay off high-interest debt like credit cards.
- Consider your debt tolerance.
- Prioritize debt-payoff if your debt worries you.
- If interest rates of low-interest debt are higher than 6%:
- Pay off debt but get your employer’s 401K match.
- If interest rates of low-interest debt are lower than 6%:
- Invest in the stock market such as S&P 500 index fund.
- Invest in retirement accounts like a 401K.
- Make the minimum payments on your student loans.
Want to know more about investing in the stock market and how to get started? Check out our recent article: 7 Stock Market Facts You Need to Know Before Investing.