Pay down debt or invest? These two ‘rule of thumb’ approaches will help guide the way

In the world of personal finance, the discussion around paying down debt vs. investing is one for the ages. This conversation often stems from a desire to maximize the value of every hard-earned dollar in hopes of securing a better financial future.

While both strategies have their pros and cons, the optimal choice can vary widely depending on individual circumstances. Unfortunately, the decision isn’t as clear as we would like it to be.

If you’d like a simple answer for this discussion, look no further. There are two “rule of thumb” approaches that are touted across the world of personal finance, and while these might be easy rules to follow, they might not help maximize your financial picture.

Rules of thumb

Cost of debt vs. expected investment return: If you expect to earn a higher return on your money by investing it compared to what your debt is costing you, then it should make sense to invest.

The rule of 8%: Historically the market has returned about 10% annually over the long term. After inflation and fees, the real rate of return is closer to 6% to 7%. Taking that into consideration, then you may want to consider paying off any higher-interest debt (8% or higher). There are no guarantees with investing. You have a greater chance of losing money than if you just saved cash, but you also have a greater opportunity to earn more money.

If you’d like a more complex answer to this discussion, there are additional pros and cons to consider for both paying down debt and investing.

Pros of paying down debt

“Guaranteed” return on investment: Paying off debt provides a “guaranteed” return equal to the interest rate being charged on the debt. For example, if you pay off a debt that was being charged an interest rate of 15%, each dollar you pay off is similar to earning a 15% return. This return is considered “guaranteed” because unlike investing in the stock market, the benefit is certain and you know you will be saving that amount of interest.

Increased creditworthiness: Lowering your debt levels can help improve your credit score, which can make it easier and cheaper to borrow money in the future.

Reduced financial stress: Reducing debt and reducing your monthly debt payment can significantly lower financial stress.

Cons of paying down debt

Liquidity risk: If you use liquid assets like savings or other investments to pay down debt this can potentially leave you unprepared for emergencies or other cash needs.

Opportunity cost: Funds allocated toward paying down debt, especially low-interest rate debt, could have the opportunity to earn more if invested or used for other life events.

Pros of investing

Potential for higher returns: Investing can offer the potential for higher returns depending on how you invest and the length of time you are invested.

Compounding growth: Investing earlier in life can allow for increased compound growth over time.

Tax advantages: Depending on the type of account you invest in — such as 401(k)s, IRAs or Roth IRAs — you can potentially reduce taxable income or participate in tax-free growth over time.

Cons of investing

Risk of loss: Investing financial assets carries the risk of loss. Investments can fluctuate in value depending on market conditions.

Risk tolerance: If you are risk adverse and aren’t comfortable with the ups and downs in the market, it might make sense to pay down debt instead.

Other considerations

The decision between paying down debt and investing is not mutually exclusive. There are a lot of factors to consider in one’s financial life when determining whether to pay down debt or invest, such as cash flow considerations, short and long-term personal and financial goals, risk tolerance, current market conditions, inflation, interest rates, potential tax consequences and many others.

Oftentimes, a balanced approach can be the best and most efficient strategy to help maximize the value of your hard-earned dollars. Partnering with a trusted advisor can help guide the conversation on which decision is right for you.

Jack Giardino is a CERTIFIED FINANCIAL PLANNER professional and President-Elect with the Financial Planning Association of Greater Kansas City. He serves as the director of planning for Inflection Point Wealth Advice in Overland Park.