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Debt and Investing
Debt and Investing
While investing is an important part of growing your wealth, reducing your debt is an important part of your net worth. Balancing the two important goals is essential to your financial health. But how do you determine which to prioritize?
It is essential to start investing early to take advantage of compounding growth. For that reason, it is essential that you do not wait to pay off all of your debt before you start investing.
The easiest way to start investing is through an employer-sponsored retirement account. If possible, contribute 15% of your pay to your retirement account. This amount can be difficult when you are first starting, so invest to at least the match if one is offered so you are not leaving part of your compensation on the table. If you can afford to invest more, then choose your percentage and try adding 1-2% each year until you get to 15%. And of course, if you are able, contributing the maximum allowable amount is ideal.
If you do not have an employer-sponsored retirement account, you can invest in an IRA or Roth IRA, depending on your income limits. The contribution limits are much lower, but it will allow you to start growing your wealth.
A taxable brokerage account can also be used for long-term savings. Just be sure you have at least 3-6 months of emergency savings in cash in a high-yield savings account to handle any unforeseen expenses. You do not want to be forced to sell investments during a market correction at a loss because you have an unexpected expense. Recessions, job losses, and market corrections have a tendency to occur at the same time.
Which Debt Should I Pay Off First?
Pay off any debt with an interest rate above 6% and any small balances. The reason is that paying off debt above 6% is a guaranteed return that market returns are not likely to beat, assuming a portfolio that isn't entirely comprised of stocks.
Paying off small balances allows you to free up more cash flow. It is also psychologically rewarding. Small is relative, so you will need to determine what is a small balance for yourself. If you aren't sure whether to focus on high interest rates or small balances first, check out this post comparing different methods of paying off debt. It is important to keep paying at least the minimum balance on all remaining debt so your credit is not affected.
Psychology
It is important to acknowledge the role that psychology can play in these decisions. The mathematically best decision may not always align with the decision that has the best psychological benefit for you. While paying off your mortgage or student loan debt rather than investing isn't usually mathematically optimal, some people may decide that paying these large balances off is best for them. Just don't delay your investing entirely until those items are paid off because you will lose out on significant compounding growth.
Now that you are beginning to form a financial plan, let's take a look at calculating how much you need to invest each month to meet your retirement goals.