Should you pay off debt or invest first? A guide to prioritizing

The decision between paying off debt or investing can be a common financial dilemma for many, especially when personal finances are tight. While both goals are crucial for achieving financial stability, the question of which should be prioritized raises a major concern: which one brings more long-term benefits? In this article, we will explore the advantages and disadvantages of each approach, helping you make a more informed decision aligned with your financial goals.

The classic financial dilemma

When it comes to personal finance, one of the most common questions is: should I pay off my debt or start investing? This question often plagues people, especially those trying to find the perfect balance between debt repayment and wealth building. The reason this doubt arises is simple: both options are important, but it’s hard to know which one should be prioritized. On one hand, debt can strain your financial health, while investments are a powerful tool for building long-term wealth.

Understanding the cost of debt

Debts have a significant impact on personal finances, primarily due to the interest that accompanies most financial commitments. When you incur debt, the amount you owe doesn’t remain constant; it grows over time as interest is applied. This can significantly affect your ability to achieve financial goals, especially if the interest rate is high. Let’s look at some common types of debt and the impact of interest on them:

Credit Card Debt: With extremely high-interest rates, outstanding balances can grow rapidly if not paid in full each month.
Student Loans: While often offering lower interest rates, they still represent a significant cost, especially if the amount is large and repayment spans many years.
Home/Car Financing: Though these loans are considered more “acceptable” due to lower rates, the total amount paid over time can be much higher than the initial cost of the financed item.

Now, to better understand the power of interest, let’s examine the difference between compound interest in your favor and compound interest against you.

Compound Interest in Your Favor vs. Against You

Compound Interest in Your Favor (investments):

You invest $1,000 with a 10% annual return.
In the first year, your investment grows to $1,100.
In the second year, you earn 10% on $1,100, or $110, totaling $1,210.
This continuous growth increases exponentially over time.

Compound Interest Against You (debt):

You have a $1,000 debt with a 10% annual interest rate.
In the first year, the debt grows to $1,100.
In the second year, you owe $1,210 (10% increase on $1,100).
The debt continues to grow, often unnoticed, leading to much higher amounts than the original debt.

Good Debt vs. Bad Debt

Not all debts are equal. Some are unavoidable and can even be helpful in building a solid financial future, while others can be extremely harmful. Here are the main differences between good and bad debt:

Good Debt:

Student Loans: Generally, they offer lower interest rates and represent an investment in your future.
Mortgage Financing: When well-managed, it helps you acquire property, an appreciating asset over time.
Investment Loans: When used to acquire income-generating assets (such as rental properties), they can be considered positive.

Bad Debt:

Credit Card Debt: With high interest rates, it can quickly turn small debts into major financial problems.
Short-Term Personal Loans: While helpful in emergencies, they often carry high interest rates and should be avoided whenever possible.

Consumer Loans (vacations, electronics, etc.): Debt incurred to finance luxuries and non-essential items can lead to financial problems, as they don’t generate any return.

Which to Prioritize?

Prioritize paying off bad debts with higher interest rates, like credit card debt and personal loans.
If you have good debt, like student loans or a mortgage with reasonable rates, you might consider investing while paying down these debts.
In some cases, it might be beneficial to pay off the higher-cost debts first while making small investments if you have a solid long-term strategy.

The power of investing early

When it comes to investing, one of the biggest advantages of starting early is time in the market. Many people believe they need to invest large sums to achieve significant returns, but in reality, time is the investor’s greatest ally. By starting early, you give your investments more time to grow, whether through capital appreciation or reinvestment of earnings. The sooner you start, the more powerful the effect of compound interest, which works in your favor, increasing your invested amount exponentially over time.

Time also allows you to better weather market volatility. Investing with a long-term vision reduces the impact of temporary fluctuations and gives you a greater chance to take advantage of economic growth cycles. This means that by holding your investments for decades, you are in a much stronger position to build wealth than if you try to seek quick and immediate returns.

Now, let’s look at the effect of compound interest over 10, 20, and 30 years. Below is an illustration of the real impact time can have on your investments.

The Effect of Compound Interest Over Time:

10 years: If you invest $1,000 with an 8% annual return, after 10 years you will have approximately $2,158.92.
20 years: With the same investment and return rate of 8%, after 20 years, your investment will grow to around $4,661.00.
30 years: By investing $1,000 for 30 years, with an 8% return annually, your investment will reach approximately $10,062.70.

As we can see, the power of compound interest grows significantly over time. The longer your money stays invested, the more it grows, allowing you to build a solid wealth foundation.

Strategies to combine both: Pay and invest at the same time

Many people believe that in order to achieve financial stability, they need to choose between paying off debt or investing. However, the good news is that you don’t have to pick just one path. With the right strategy, it’s possible to do both at the same time, balancing debt repayment with starting investments. By taking an even-handed approach, you can pay off your debts while simultaneously building your wealth over the long term.

One of the most effective ways to do this is to divide your income. Instead of directing all your money to a single goal, you can create a financial plan that allocates part for debt repayment and part for investing. Common ratios include 70% for debt payment and 30% for investments, or 50% for each goal. The key is to tailor the split according to your financial situation, allowing you to pay down high-interest debts while beginning to invest for the future.

Additionally, financial tools can be great allies to help automate both investment contributions and debt payments. By setting up automatic payments, you ensure that you won’t forget to meet your obligations or invest regularly. Personal finance apps and investment platforms often offer features that help set goals and schedule transactions, making the process more efficient and less prone to errors.