It's one of the best feelings to have money left at the end of the month, after essential expenses and bills are paid. But what should you do with that spare cash? Is it better to invest or use it to pay down debt? Both are important for your financial well-being. But striking the perfect balance looks different for everyone.
All debts aren't created equal
There's good debt and bad debt. The kind of debt you're dealing with will dictate how to prioritize paying it off.
Good debt: Slow and steady wins the race
Although paying off student debt or a mortgage can take up to 30 years, these are considered "good" debt because the money is invested—in your future or a home. Good debt typically has a low interest rate (between 3% and 8%) and is meant to be repaid with a slow and steady approach. Many people chip away at good debt with their monthly payment over the long haul.
Bad debt: Race to the finish line
High-interest debt (like from credit cards used for nonessential purchases) is considered "bad" debt. Accumulating credit card debt without consistently paying it off can hurt your credit score, make the amount you end up paying back more than the cost of your original purchase, and make it harder to save and plan for the future. Each billing cycle that there's an unpaid balance, double-digit interest charges get added to your balance. This compounds the slower you pay your balance off. It's best to get rid of bad debt by paying off as much as you can as fast as you can, or avoiding high-interest purchases if you can't pay it off right away. The longer it takes for you to pay off your balance, the more total cumulative payments you'll have to make on your purchases because each month's unpaid balance will be charged with interest, adding on to the amount you owe.
I understand the types of debt. Now what about investing?
There's a saying about investing: $1 invested today is better than $1 invested tomorrow. Here's why: The effect of compounding can be quite powerful, since if you have gains on your initial principal, you would then start making gains on those gains and so on. The effect of compounding makes early investing, particularly for longer-term goals like retirement, that much more enticing since the earlier you start investing, the more potential compounded returns you can expect to make.
I want to start investing but I have debt
As long as you're making all required minimum payments, here are a few things to consider. If you have a retirement savings account at work and your employer matches your contributions, try to contribute at least up to your employer's match. Otherwise, you're leaving money on the table. After that, try to save enough money to cover 3 to 6 months of essential expenses and pay off high-interest debt from credit cards or private loans. You don't need a large sum of money to invest. What's important is to start. Even if it's a small amount like $10 a month, it can feel good to know you're developing smart money habits by giving your savings a boost.
Compare your debt's interest rate to the average investment rate of return
Stock market returns vary greatly from year-to-year. For this example, let's use the 10% historical average S&P 500 return, prior to inflation. Compare that to your debt's interest rates. If your credit card is charging you 20% in interest but your investments are expected to earn 10% over the long term, the money you're earning through investments can't keep up with how fast your debt is growing. But let's say your only debt is a student loan with a 5% interest rate. If you've got long-term investments with a potential return of 10%, your investments are growing faster than your debt.
The perfect balance
Striking the perfect balance between debt repayment and investing can take some trial and error. Make a plan that you feel comfortable with and be flexible to adjust it with the changing priorities in your life. After all, it's your financial future.