Building wealth and tackling debt go hand in hand. But what’s the right balance between the two? Is it better to focus on your debt first? When and how should you start investing – even when you’re in debt? Given that the average American has more than $90,000 in debt, which includes things like credit cards, mortgages, and student loans, these are important questions to answer as you develop and pursue your financial goals.
How Should You Prioritize Different Types of Debts?
Not all debt is the same. Arguably the biggest way to differentiate your debt is by interest rate. In almost all cases, prioritize the highest interest rate debt first, which usually is credit card debt. As of Q3 2021, the average interest rate charged by credit cards was approximately 17%, according to the Federal Reserve.
Average interest rates for other common types of debt include*:
• 30-year mortgage: 3%
• Car loans: 4%
• Student loans: 6%
The higher the rate, the more you’ll pay in interest over time. Money that could otherwise go toward your future goals. Start by outlining all your current debt and their respective interest rates and begin prioritizing those with the highest interest rates.
How Should You Balance Paying Off Your Debts While Contributing to Investment Opportunities?
Should you wait until you’re entirely debt-free to start investing? Absolutely not. But depending on the type of debt you have, it may make sense to put most of your attention on that first.
As mentioned above, pay off high-interest debt before pursuing an investment strategy.
Why? Take credit card debt, for example. If the average credit card interest rate is 17%, and the stock market, on average, returns about 8-10%, you can see how debt will compound faster than investments. Sure, some years the market will exceed that 8-10% average, but on the flip side, it can also be much lower. When you have high-interest debt, play it safe and tackle that first so it doesn’t accumulate more.
In most cases, yes, pay off your high-interest debt first. But if your employer offers a 401k match, you should at least contribute enough to get the full match. This is literally free money. And what better way is there to build wealth than with free money?
Are There Other Considerations You Should Make When Balancing Your Debt and Investments?
Once your debt is under control (yay!), your next step should be setting cash aside to cover unexpected expenses and emergencies (e.g., your car breaks down, major home repair, etc.). Without this, most people generally are left with two bad options: either use credit cards (which restarts that battle) or dip into retirement accounts like a 401k or IRA, which carry significant tax penalties.
Automating your savings is one of the best ways to stay on track. Once you have a payoff plan for your debt, if there’s any money left over, set up a recurring transfer to a savings account. You don’t have to think about it or be tempted to spend it while you’re still building up your emergency savings.
Is It Ever a Good Idea to Use Existing Investments to Pay Off Debt?
Possibly. It really depends on your financial situation and investments though.
Again, when those investments are in tax-advantaged accounts like a 401k, it’s a (very) bad idea to dip into those to pay down debt. If the investments are stocks, it’s important to be mindful of the capital gains tax you’ll face, which can be substantial depending on when you purchased the stock, its purchase price, and its current value.
One situation where it might make sense to use existing investments to pay off debt is if you have a large position in one stock (e.g., vested restricted stock or stock options from your company). If a large piece of your net worth or investable assets are tied into one company, it could be beneficial to use some of that investment to pay down high-interest rate debt. There even are ways to potentially sell some of that stock with little-to-no tax impact.
For many, the road to building wealth starts with tackling debt. It might seem daunting, but it truly opens the door to sound investment strategies that can help you realize your life goals – whether that’s to retire early, buy a home or something else.
*These averages don’t apply to everyone, however. Younger consumers are often subject to higher rates than the national averages.