Pay off debt or invest? A simple way to decide
If you have debt and some spare money, the key comparison is this: paying off a debt is like earning a guaranteed return equal to its interest rate. Each dollar you pay stops generating interest, and that saving is certain.
The rest of the decision comes down to comparing that number with what you could reasonably earn by investing, after tax, and accepting that it is not guaranteed.
The rule, by interest rate
- High interest, above about 7-8%: pay it off first. This usually means credit cards, payday loans and many personal loans. No sensible investment can reliably beat that.
- Low interest, below about 3-4%: there is usually no rush. An older mortgage at a low rate may cost less than a savings account pays.
- In between: there is no single answer. Splitting your money is a valid choice, and peace of mind counts too.
These thresholds are rough guides, not rules. What matters is making the comparison with your own numbers.
Why the numbers do not compare directly
A debt at 7% and an investment expected to return 7% are not equal, for three reasons:
- Certainty. The savings from paying down debt are guaranteed. An investment can return more, less or even lose money.
- Taxes. Gains on taxable investments are generally subject to tax, while the interest you avoid is not taxed. At a 15% rate, a 7% return leaves about 5.95%.
- Liquidity. Money you use to pay down a loan does not come back easily. That is why the order below matters.
An example with a credit card
You owe $5,000 at 18% interest. Here is what happens depending on your monthly payment:
| Monthly payment | Time to pay off | Total interest |
|---|---|---|
| $150 | 47 months | $1,983.60 |
| $300 | 20 months | $797.17 |
Doubling your payment saves you over $1,180 and more than two years. To match that by investing, you would need a guaranteed 18% a year, which does not exist.
An example with a mortgage
A mortgage is less clear-cut. Say you have $10,000 and a loan at 4%, and you are torn between paying it down and investing:
- Paying it down saves you 4%, guaranteed. As this amortization example shows, it can add up to a lot over the years. If you itemize and deduct mortgage interest, your real saving is a bit less.
- Investing could bring more over the long term, but the return is not guaranteed and could be negative in any given period.
If investing would keep you up at night, or you might need the money in a few years, paying down the debt can be the reasonable choice, even if it loses on a spreadsheet. If you have decades ahead and can tolerate the ups and downs, investing may make sense.
Do not miss an employer match
There is one important exception to the order below. If your employer matches your 401(k) contributions, that match is an immediate return that is hard to beat anywhere. For many people, it makes sense to contribute enough to get the full match, even while paying off debt, unless the debt rate is extreme. Check your plan’s vesting rules to see when the money is really yours.
A practical order
- Pay the minimum on all your debts. Missing payments costs more than almost anything else.
- Build a small cushion, about one month of expenses, so the next surprise does not go on a card.
- Get your employer match, if you have one.
- Clear expensive debts, starting with the highest interest rate.
- Finish your emergency fund.
- Save and invest for your goals, and consider whether paying down cheap debt is worthwhile.
Paying the highest rate first, sometimes called the avalanche method, costs the least. Starting with the smallest balance, the snowball method, costs a bit more but gives you quick wins. A plan you stick with beats a perfect one you abandon.
Before paying extra, check three things
Prepayment penalties. Some loans charge a fee for paying early. Check your documents.
Where the extra money goes. Tell the lender to apply it to principal, then confirm that it did.
Student loan details. Federal student loans have protections and repayment plans that private refinancing would remove. Understand what you would lose before paying off or refinancing them.
You can see what your interest costs with the loan calculator and how your investments might grow with the compound interest calculator.
This is general information, not personal advice. If you are struggling to make payments, contact your lender or a nonprofit credit counselor as soon as you can. There are usually more options before you miss payments than after.