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She's a Lot
Ambition Looks Good on You.
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Reader Q&A: Debt Pay-off or Investing?
Dear She's a Lot,
I want to start investing, but I have some student loans and am currently putting all my extra money towards those. Would it be irresponsible to invest some of that money instead? I'm worried about accruing a lot of interest, but I also don't want to wait too long to start investing. What should I do?
– Indebted Investor
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Dear Indebted Investor,
This is a great question! Wanting to get into investing as early as possible is a good move, because as we know, $1 invested at 25 is worth $8.42 more on average at retirement than $1 invested at 35.
But it is still important to carefully consider which option is most financially responsible for your situation, as you seem to be doing.
The answer is, it depends. It depends on how much debt you have, what the interest rate of that debt is, and most importantly, what you're comfortable with.
Let's run the numbers.
**assuming 7% average annual returns
If you have $20,000 in student loans with an interest rate of 5%, here's how it would play out if you paid $500 a month without investing versus paying only $400 and investing the additional $100:
Paying $500 a month, investing $0
- pay it off in 3 years, 8 months
- pay $1,924.27 in interest
- have $0 invested
- earn no profit
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Paying $400 a month, investing $100
- pay it off in 4 years, 9 months
- pay $2,473.83 in interest
- have $6,738.92 invested
- earn a net profit of $1,750.51
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So, even though you're paying a little more interest, it's only $549.56 more. Is that a number you're comfortable with?
However, these numbers will look different if you have larger loans or a higher interest rate:
If your loan is $160,000 at 5%, paying $500 a month, you'll never pay it off. It would take $800 and 36 years to pay it off at a minimum, paying $184,734.15 in interest. That's a big number. In this case, because the debt is so high, lowering your debt payment is not a good idea.
Alternatively, if you have the same loan amount but a higher interest rate, here's how two different plans would look:
Paying $500 a month, investing $0
- pay it off in 4 years, 1 month
- pay $4,429.38 in interest
- have $0 invested
- earn no profit
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Paying $400 a month, investing $100
- pay it off in 5 years, 5 months
- pay $5,979.56 in interest
- have $7,876.42 invested
- earn a net profit of $1,896.86
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In this case, you end up with an extra $1550.18 in interest. While you can still potentially earn a bit investing, you're ending up paying over 125% of your total loan amount ($20,000). For some, that's getting into the territory of paying too much in interest.
The catch here is really how long it will take you and how high your interest rate is. If you have a very small loan (think under $7-10,000) that you can knock out in less than two years, that peace of mind is probably worth waiting to invest. And if you have an interest rate above 6% - you're likely not going to outpace your loan interest with investing, or at least not significantly.
Want to run these numbers for yourself with your exact loan amount and interest rate?
Ok, so what if I want to invest but feel like I can't?
Take these steps to tackle your debt/investing debate:
Calculate how much interest you'll earn
Once you see that number, you'll know in your gut if that's something you're comfortable paying or not. If it feels too high, that's a good sign that it's probably more worth it (for your own peace of mind) to just focus on paying it off first to pay as little interest as possible.
Consolidate or refinance loans
If you have high-interest debt, you can sometimes consolidate it into one loan type with a lower rate than your highest, refinance it into a different type of loan with a lower rate, or, in the case of credit card debt, use balance transfer cards to lower your rate.
If your rate is either too high for you to actually pay off your debt or just too high to make investing worth it, this can be a good option.
Knock out high-interest debt
If you can't do any of the above or you've already done what you can and still have some high-interest debt, focus on knocking that out. Not only will it give you peace of mind, but it will free up your finances for you to invest.
It all comes down to personal situation and comfort level, but our Debt vs. Investing can help you come up with real numbers so you can make an informed decision.
Wishing you a rich life,
Lora at She's a Lot
