By Matt Becker

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While everyone faces their own unique struggle to balance all of their financial responsibilities, one of the most common questions I get is some version of this: should I pay off debt or invest for the future?

Whether you’re dealing with student loans, credit cards, auto loans, or a mortgage, debt can feel like a huge weight on your shoulders and you probably want it gone as soon as possible.

But you’d also like to be saving for future goals and you know that it’s important to start investing early. You hate the idea of completely ignoring that part of your finances.

So what are you supposed to do? Should you go all-in on your debt until it’s gone? Should you make just the minimum payments so that you can invest as much as possible? Or is there a middle ground that helps you get the best of both worlds?

This post shares a 7-step process you can use to make that decision, including a last step that’s almost never discussed and has a huge impact on your end result.

Let’s get into it!

Step 1: Build a small emergency fund

No matter how much debt you have and how high your interest rates are, it’s a good idea to build at least a small emergency fund before dedicating extra money to your debt, and even before investing

Some people will say this is crazy given that even the best savings accounts are only paying around 1.5% interest these days. And if you have credit card debt with double digit interest rates, they’ll say that you’re basically lighting money on fire by keeping it in a savings account.

But there are three big reasons why building at least a $1,000 Stage 1 emergency fund makes sense, no matter what your debt situation looks like:

When the next unexpected expense comes up (and it will), you’ll be able to pay for it from savings instead of resorting back to debt. You’ll get into the habit of saving on a regular basis. You’ll feel less stressed and more in control knowing that you have money set aside for the unexpected.

That’s why I would suggest paying the minimums on your debt and automating whatever savings you can into a savings account until you’ve built it to at least $1,000. Then you can move on.

Step 2: Max out your 401(k) employer match

A 401(k) employer match usually represents an immediate and guaranteed 50%-100% return on investment. That’s higher than just about any interest rate on any loan out there, which means that taking full advantage of it should typically come before putting extra money towards your debt or other investments.

The only thing to watch out for here is a potential 401(k) vesting schedule. Depending on your company’s vesting terms and how long you plan on being at the company, that match may not be quite as valuable as it seems on the surface.

In most cases it will still be the logical second step, but you should double-check and make sure.

Step 3: Negotiate your interest rates

Beyond refinancing, the interest rates on most loans are fairly set in stone.

But credit cards are ripe for negotiation and there are plenty of examples of people lowering their interest rates simply by asking. Doing so will not only save you money, but it will potentially free you up to start investing sooner rather than later.

Here’s a helpful script you can use to request a lower interest rate. The worst that happens is they say no and you’re in the same spot you’re in now.

Step 4: Prioritize high-interest debt

Let’s assume that a balanced investment portfolio should return somewhere around 6% over the long term, which is reasonable given current market forecasts by leading experts.

What that means is that extra payments towards any loan with an interest rate HIGHER than 6% represents a better return than what you’d expect to get from traditional investments. And paying off debt comes with the added benefit of being a guaranteed return, while traditional investing is always an up and down ride where anything is possible.

So while there’s no clear line that marks something as high-interest debt, I tend to look at it as any debt with an interest rate higher than 6%.

And other than maxing out your 401(k) match, I would generally encourage you to put extra money towards that high-interest debt before investing elsewhere for the simple reason that it’s both guaranteed and better than what you expect to receive from your investments.

Step 5: De-prioritize low-interest debt

On the other end of the spectrum, there are certain loans with a low enough interest rate that investing almost certainly makes more sense than paying them off early.

How low is too low? Again, there’s no clear line in the sand but 3% is a good rule of thumb. For any loans with an interest rate under 3%, you can pay the minimums and move on to the next step.

Why 3%? A couple of years ago Ben Carlson ran the numbers and found that the WORST 10-year return for a balanced investment portfolio was just under 3%.

In other words, even during market downturns you’re likely to get at least a 3% return from your investments over the long term, which makes investing likely to produce better returns than paying off that low-interest debt.

Step 6: Trust your gut and strike a balance

All of the steps above are pretty straightforward. While you could certainly disagree with the specific cut-off points for high- and low-interest debt, the decisions you’re making along the way are pretty cut and dry.

This is where all that clarity goes out the window.

If you’ve followed all the steps above and you still have extra money available, that means that you’re deciding between:

Investing in your 401(k), IRA, or other retirement account

Putting extra money towards debt with an interest rate from 3%-6%

The truth is that there’s no clear cut answer here. Neither route is guaranteed to produce a better return or more financial security.

And both are important. Paying off debt saves you money and reduces your financial obligations, and investing for the future gives you the freedom to make decisions based on what makes you happy, rather than what makes you money.

In other words, both are key components to reaching true financial independence.

So, here’s how I would approach it:

Default to a 50/50 split. That is, 50% of your extra money goes towards investment accounts and 50% goes towards debt. Adjust the percentages based on personal preference. In all seriousness, listen to your gut about which one feels more important or more satisfying, or which one will help you sleep at night, and don’t be afraid to lean in that direction. No matter which way you lean, make sure that at least 25% of that extra money is going towards each goal so that you’re making at least some progress in both directions.

Step 7: Snowball your debt payments into your investments

This is the step that’s often ignored, and it’s also the step that can make or break your entire plan.

In order for the logic above to make sense, you have to take all of the money you’re putting towards your debt and, once that debt is paid off, redirect it towards your investments (or something else that either saves you money or earns a positive return).

For example, let’s say that you have a loan with a $50 minimum payment and you’re also putting an extra $100 towards that loan every month. In order for the logic above to work, you have to start putting that $150 towards your investments each month as soon as that loan is paid off.

If you spend that $150 instead, then you’d actually have been better off putting all your extra money towards your investments from the beginning, no matter how how high the interest rate on your loan was or how much you owed.

The reason for this comes down to two things:

Time The importance of your savings rate

With the exception of your mortgage, most loans have repayment periods of 10 years or less. On the other hand, you might have 20-40 years of investment contributions before you’re fully financially independent.

So for the most part you’re going to be contributing to your investment accounts for a lot longer than you’ll be paying off your debts. Which means that if you don’t redirect those debt payments towards your investments once your debt is paid off, you’re giving up many years of potential contributions.

And those years of missed contributions will outweigh any benefit you get from putting extra money towards high-interest debt for the simple reason that your savings rate is more important than the return you earn on that savings. Contributing money for multiple decades will result in a greater net worth than doing so for just a few years, even if the return you get from those few years is much higher.

So the bottom line conclusion is this:

If you can commit to redirecting your debt payments into your investments once your debt is paid off, then following the first 6 steps above is the right way to go.

If you aren’t able to do that and your debt payments are spent elsewhere once the debt is paid off, then from a purely financial perspective you would be better off putting 100% of your extra money towards your investments from the beginning, no matter what the interest rates are on your debt. (I do realize that there are non-financial considerations that might go into this decision as well — such as stress and anxiety levels — and those are important to take into account on top of the raw numbers.)

Digging into the numbers

If you’re satisfied with that conclusion as is, then great! You can move on and get started with your own investment/debt repayment plan.

But if you’re a nerd like me and you really need to understand the numbers, you can check out the spreadsheet I used to verify all of this here: Paying off Debt vs. Investing.

The basic scenario I ran was that you have a 10 year loan with an $X minimum payment, $Y extra money to either invest or put towards debt each month, and a 30 year investment horizon.

What I found is that if you snowball the minimum payment once the debt is paid off — that is, once the debt is paid off you contribute both the $X minimum payment and the $Y extra money towards your investments — then the conventional wisdom holds true:

If the interest rate on your debt is the same as your expected investment return, it doesn’t matter how you allocate that extra payment. Your net worth after 30 years is the same no matter what. (Ignoring the fact that the return on debt payments is guaranteed while the return on your investments is not.)

If the interest rate is higher, you’re better off putting the extra money towards the debt until it’s paid off.

If the investment return is higher, you’re better off investing all the extra money from the beginning.

But if you DON’T snowball the minimum payment — that is, once the debt is paid off the $X minimum payment goes wherever and you only invest the $Y extra money — then it doesn’t matter what the investment return, interest rate, or loan balance are. No matter what, you are better off investing 100% of the extra money from the very beginning.

That might sound crazy, but the reason why this is true all comes down to the total amount of money you end up contributing over your lifetime.

As long as you’re snowballing your debt payments, your total contribution is the same no matter how you split up the payments over time. But if you don’t snowball your debt payments, contributing all your extra money towards investments from the beginning results in a greater total contribution, which means that you end up with more money.

For example, let’s assume that you have a $15,000 loan with a 25% interest rate and a 10 year repayment term. The minimum payment is $341.24 and you have $200 extra dollars each month that you can either put towards your debt or your investments, which will earn 6% per year.

If you put all of that extra money towards your debt until it’s paid off — which is what the conventional wisdom would suggest — and then, once the debt is gone, invest just the $200 per month and not the $341.24 minimum payment, you end up making a combined $86,332 contribution towards your debt/investments over 30 years and end up with a net worth of $155,976.

If you instead put all of that extra money towards your investments from the start, and still don’t snowball your minimum payment once the debt is gone, you end up making a combined $112,949 contribution towards your debt/investments over 30 years and end up with a net worth of $200,903. That’s $26,617 more contributed and a net worth that’s $44,927 higher.

If, on the other hand, you DO snowball your minimum debt payments once the debt is paid off, the math is very clear that you’re better off putting all your extra money towards that 25% interest rate debt until it’s gone.

For what it’s worth, I used this spreadsheet to run crazy numbers like a $500,000 loan with a 100% interest rate compared to investments that return -25% and you still come out ahead after 30 years by investing all the extra money from the start unless you snowball those minimum payments. And the reason is that your total contribution is much higher when you go that route.

But please feel free to play around with the numbers and draw your own conclusions. If you find anything interesting, please leave a comment letting us know!

How do YOU balance paying off debt with investing?

For a quick recap, here’s how I would approach the question of paying off debt vs. investing:

Build a small emergency fund Max out your 401(k) employer match Negotiate your interest rates Prioritize high-interest debt De-prioritize low-interest debt Strike a balance between both goals in a way that feels good to you Once your debt is paid off, redirect those payments towards your investments

It’s a process that uses math to make sure you’re getting the most out of your money while also giving you room to take your personal preferences into account.

But this is a complicated question and I’d love to hear from you as well. How are you striking a balance between these two goals? Or how did you do it in the past and is there anything you wish you had done differently?

Feel free to share your thoughts in the comments below. I’m sure we could all learn from your experience.