Pay off debt or invest? It’s simpler than you think.

by Rob Bertman, CFA®, CFP® in Debt, Goals, Investing, Retirement, Wealth building
October 14, 2020
pay off debt or invest

Pay off debt or invest? It’s simpler than you think.

Is it better to pay off debt or invest? It doesn’t have to be complicated. 

Let’s start off with the idea that if you put extra cash in a savings account, invest for the long term, or pay down debt, it’s a win. Any one of those will build your net worth and help you reach your financial goals.

Yes, the interest rate on the debt and where you invest will help you optimize your wealth, but it’s all about coming up with the extra money in the first place.

Assuming you have that going for you, congratulations! 

Here is a simple framework you can use to see where your money should be going.

Lay a strong financial foundation

Let’s start with the most important things you should have in place. These are the first places to save money, invest, and pay back debt – one in each category.

Not only do these set you up for financial freedom but it also drastically reduces your financial stress and anxiety. 

Do nothing else until you check all 3 of these boxes. Make these your short term financial goals.

Pay off credit card debt…ALL of it. Not just because of the interest rate.

Now, you might be thinking that I’m just saying this because credit cards generally are the highest interest rate debt. That is true, but there’s another reason too.

Credit card debt is the “toe over the line” that leads to all sorts of financial problems. It’s the gateway drug of personal finance.  It says, “I’m ok with carrying debt.”

No, no no!

The first debt to pay off is ALL credit card debt. Even the 0% ones. 

Then ALWAYS pay off the full credit card balance each month.

Start an emergency fund

emergency fund

An emergency fund is your insurance from going into debt in the first place. Think of it as protection against getting into a bad financial situation. Being prepared and having a cash cushion can prevent a lot of stress. 

The goal here is not to optimize your investment return. It’s simply to sit there on the ready when you need it, so this cash should be sitting in a checking account or a savings account. 

Plus, wouldn’t it feel great to have a bunch of money sitting in your bank account?

COVID-19 is the perfect example of why we need to have solid emergency funds in place. Though this has affected the entire world, there are also unique circumstances that can happen to any individual at any time.

Calculate your emergency fund by taking your monthly expenses (not income) and multiplying it by the number of months you’d like to have in cash. Most experts recommend having an emergency fund of 3 to 6 month of expenses.

For this foundational step, let’s just start with a 3 month emergency fund.

Eventually, you may need a bigger one depending on your situation, and we’ll go into that later.

Max match from your employer retirement plan

Many jobs offer a retirement plan like a 401(k) or 403(b). These are great tools to invest over the long term. Plus, it is taken out of your paycheck so you don’t even take it home.

If your employer offers a matching program (meaning they’ll contribute money to your account if you do), take it. 

These come in all shapes and sizes, but the most common ones I’ve seen are that they’ll match half of what you put in up to a certain percentage of income. For example, if you put in 4% of your income, they’ll match 2%, or if you put in 6%, they’ll put in 3%.

In these examples, you get an immediate 50% return on every dollar you put in. You put in $1 out of your pocket and it instantly becomes $1.50 because of their $0.50 contribution. 

That’s a fantastic way to boost your retirement savings! Contribute to your retirement account up to the maximum employer match to start.

*Note: The max match is different from “maxing out” your retirement plan. Here’s how

  • Maxing out retirement plan – Reaching the retirement plan contribution limit ($19,500 in 2020 for 401(k)s)
  • Getting the max employer match example – Your employer will match 50% of your contribution up to 6% of your income. So you put in 6% and they match 3%.

If you only completed these financial goals, that’s a success!

It doesn’t have to be that complicated. Keep it simple until you reach these milestones.

financial foundation

Save, invest or pay off debt – Round 2

Once you are credit card debt free, have a 3 month emergency fund, and are getting the maximum match from your employer plan…

Wait…Just take a moment and picture how amazing that would feel…

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Ok…moving on…

It’s time to prioritize the next phase.

Just like laying the financial foundation, we’re going to want to tackle things in all 3 categories of saving, investing, and paying off debt.

But first, there is an important question to ask.

Is it better to pay off debt or invest?

Ready to have your mind blown? 

Paying off debt and investing are the same thing.


It’s true. Both build your net worth. Both will give you a rate of return on your money.

What do I mean by that?

Whether you invest hoping to earn a 7% return or pay off debt at 7%, it’s the same thing. You are getting the same return on your money.

For example, if you invest $1,000 per month for 5 years and it earns 7%, you end up with $71,593.

Now let’s say you have a $100,000 home equity loan at 7%. If you paid an extra $1,000 toward principal each month for 5 years, guess how much lower your loan balance would be? Any guesses?

That’s right, the loan balance would be $71,593 lower than if you just made the minimum payments. Your net worth would end up in the same place vs investing.

is it better to pay off debt or invest?

There is one major reason that I’d rather pay down debt if I’m expecting the same return.

Investing, whether it’s in stocks, bonds, mutual funds or ETFs, means taking risk and having to deal with volatility in order to earn 7% by investing. The shorter term the investment horizon, the more random the returns.

But by paying off a 7% loan, you get a risk-free, tax free, guaranteed return on investment IMMEDIATELY.

That’s why high interest debt payoff  beats investing.

The side benefit? Once you pay off the debt, it lowers your monthly expenses because that debt payment goes away, freeing up monthly cash flow.


What debt should be paid off first?

what debt should be paid off first?

We now know that paying down debt and investing are basically the same thing. Now that the credit cards are behind you, let’s prioritize the rest.

*If you haven’t already done so, create your personal balance sheet so you can get things organized heading into this.

Long term investing has historically returned between 7-10% with a diversified portfolio. But given that the average investor has had to weather investment risk and volatility to get that, it makes sense that we’d be willing to pay down debt with a slightly lower interest rate than the return we’d expect from investing.

For that reason, I consider high interest debt to be loans with interest rates above 5%, so that’s what we’re going to tackle in this phase.

Usually this includes HELOCs, home equity loans, personal loans, private student loans, federal student loans, and high interest rate car loans, but often excludes a home mortgage and most auto loans.

*If you owe more in federal student loan debt than you earn, you may want to explore income driven repayment with possible forgiveness rather than paying them off. If you want help with this, Student Loan Planner can give you some great guidance.

What’s the best way to organize it? Smallest debt first? Highest interest rate?

The ratio I like to use is minimum payment/amount of debt owed. 

Debt with high payments/debt are usually on the fastest track to be paid off, so we’re just sprinting to the finish line to free up cash flow and as soon as possible.

Line up your debt in order of this ratio, and focus all the extra payments on one loan at a time, kind of like using the debt snowball.

For example, if you have a $2,000 personal loan with a $200 monthly payment and a $5,000 debt with a $100 payment, you’d pay off the $2,000 debt first.

That being said, if you want to pay off the smallest balances or the highest interest debt first, that’s fine. The most important thing is that you pick an approach that resonates with you because you’re most likely to do something that feels right to you.

The most important thing is to get it done!

Where to invest next

where to invest

Since you’re getting the maximum employer match, let’s get going on the next best investment accounts to use.

Next comes the Roth IRA.  A Roth IRA contribution is made with after-tax dollars, but then it grows tax-free and you can take it out tax-free and without penalties after you become 59 ½ years old. This money is never taxed again and also has a lot more flexibility than a Traditional IRA.

There are income limits and contribution limits for this account though. Even so, you may be eligible to make a backdoor Roth IRA contribution. Check with a tax pro to see your eligibility.

After the Roth IRA, the next step is to invest using a brokerage account. Think of a brokerage account like a savings account. You can put in what you want and take out what you want without limitation or penalties. 

The difference though is that you can manage investments within it kind of like a retirement account. However, any capital gains, dividends or income are taxable.

Why invest in a brokerage account before going back to your employer retirement plan?

The reason is that just like we don’t want people to be “house poor”, there’s also something I call “retirement plan poor” meaning that there is money there, but it can’t be accessed without taking out a loan against your 401(k) or taking a costly early distribution.  

What happens if you have mid-term financial goals (10-20 years) where you want to grow that money for early retirement, an investment property, or a home renovation? A brokerage account will allow you to do that without penalties.

We want to combine maximizing long term growth and favorable tax treatment (retirement plans) with flexibility and the ability to access our money (brokerage account).

So here’s the pecking order of investing so far:

Max match, Roth IRA (or backdoor Roth IRA) – if eligible, brokerage account up to $25,000.

Fully funded emergency fund 

Maybe 3 months of expenses is enough and you’d have that saved up as part of your strong financial foundation. But maybe you need 6 or even 12 months of expenses.

How big of an emergency fund do you need? It depends on how much your income varies, family size, and how much “stuff” you have.

For example, a single person with no kids and a steady job might only need 3 months. But a family of 5 with a decent sized house and a couple cars should probably get closer to 6 months. Single income households and people paid on commission should have closer to 6 months too.

If you own your own business, then you might want to go between 6-12 months of expenses.

Pick the number that would make you feel at ease knowing you have that money in the bank. Err on the larger side. With the pandemic, it seems like we should all strive for at least 6 months of expenses.

Round 2 Summary

After your financial foundation is set, let’s do the next best things with your money.

Pay off all debt above 5%. You can arrange it by debt amount, interest rate, or my personal favorite minimum payment/debt balance.

For savings, finish out your emergency fund. I’d love for you to get to at least 6 months, but you can do what you feel best about.

As for investing, we want to get you more flexibility. Investing in a Roth IRA has many benefits if you’re eligible to contribute. Setting up a brokerage account will mean that 10+ year but pre-60 year old goals have the opportunity to grow quickly and you can access it at any time.

Roth IRA & brokerage account

Save, invest or pay off debt – Round 3

Round 3 is all about getting out of debt and staying out of debt. These goals might be longer term depending on where you are today. 

That being said, I believe anyone can get here. Especially if you use my 50/50 Rule as your income grows.

Pay off all non-mortgage debt + Increase your mortgage payment

It’s time to pay off all debt outside of your mortgage. 

Yes, that includes the financing for your washer & dryer, money owed to family members (even if they don’t want you to pay it back), auto loans, etc. Pay off anything that you are making payments on.

This is also where you can accelerate yourself toward being mortgage free. Increase your mortgage payment by 25%-50% and start seeing that big number come down at a much faster pace.

Even if your interest rate is super low (in the 2%s or 3%s), make a commitment to paying it off.

Save for major expenses

Anything you’re planning to buy of value should be saved up in advance. No more payment plans. No more new debt!

Pay cash for a car. Save up for moderate sized home projects. It really helps you feel the weight of what you’re about to spend when you have to part with it all at once.

If you’re skeptical because a company or store throws a 0% financing option at you, remember how bad it felt to have to make payments. If you need more help, why on earth would someone offer you 0% financing on something? Hint: It’s because they want you to buy it and they’re charging you more on the front end.

Buying a car isn’t like buying a coffee at Starbucks. The stakes are much higher for these major purchases, so make a solid financial decision. 

Invest in other family goals

As far as investing goes, this is where you save for kids’ college in a 529 plan if it makes sense for your situation. 

A 529 plan is kind of like a Roth IRA but for your child’s education. You put money in after-tax (some states offer a state tax deduction on the contribution). It grows tax-free and you can take it out tax free as long as it’s for qualified educational expenses.

Max out your retirement plan, then go back to the brokerage account you started to build in the last step to save for long term financial goals you want to accomplish before you turn 60.

Round 3 Summary

We’re cleaning up the edges here.

Get rid of all non-mortgage debt, save up for major purchases going forward, start working on your other family goals.

pay off non-mortgage debt

The missing ingredient

My first crack at starting my own business was a total flop.

I had created an online course to help people create their own financial plans. People could figure out how much to save for retirement, organize paying back their debt, how to save for college, buy a house, etc.

But at the end of the day, it wasn’t a success. Why?

Well, it took me many conversations to get to the bottom of it, but there was a theme:

“What difference does it make if I know what I have to do to reach my financial goals if I don’t have the money at the end of the month to make it happen?”

This was so true. 

That’s when I got the idea for Family Budget Expert. If I could help families go from paycheck to paycheck to having money left over at the end of the month, that would unlock their ability to reach financial independence.

Honestly, none of what I outlined above makes a difference unless you have money at the end of the month to put towards it.

Though it’s helpful and can help you focus your money on fewer things to reach your goals faster, tt doesn’t help you create a family budget that sticks.

If this is an area that you’re struggling with or is creating stress in your relationship, I’m here to help.

If you’re not ready to talk but want to learn more:

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