Invest or pay off debt? Why you should do both

You should pay off debt if…

While saving up for retirement or a rainy day is essential, if you’re carrying a huge debt load or a poor credit score, all that saving could be for naught. You may get ahead on your future only to realize your present is eating away at those financial gains.

Here are some signs that paying off debt might be the more prudent option.

You have debt with an interest rate above 7% (e.g., a credit card)

As a general rule of thumb, if the interest rate on your debt exceeds the average annual returns on a reasonable investment (7% to 10%), it’s best to pay off the debt first. That’s because, on paper, any potential profits from your investments will be wiped out by your interest payments, so there’s little point in investing until the debt is cleared.

Some experts say that any debt above 6% should be paid off before investing. Depending on your situation, you might consider the more conservative 6% threshold as well.

» MORE: How to get out of debt

You have a DTI ratio above 36%

Your debt-to-income (DTI) ratio is a measure of your combined minimum monthly debt payments divided by your gross monthly income, expressed as a percentage. So if you bring home $5,000 and your minimum monthly payments add up to $1,500, your DTI is 30%.

If you’re carrying debt above a 7% interest rate, have a DTI above 36% or a credit score below 670, prioritize paying off debt.

DTI matters because some lenders won’t consider borrowers with DTIs above certain thresholds. For example, the cutoff to get approved for a mortgage is typically 36% (although some lenders may allow up to 43%). So if your DTI is too high for your next big loan, you might need to pay off a loan or two to lower it before you start investing.

Your credit score is below 670

If you know you’ll be applying for another large loan within the next few years, such as an auto loan, mortgage or student loan refinancing, then repairing your credit may be more urgent than investing since the former can help you score lower interest rates (and get approved in the first place).

Actions like paying your bills on time, making payments on past-due accounts and paying off credit cards to lower your credit utilization ratio can all help to repair your credit.

Your debt is causing mental stress

If your debt load is causing stress, anxiety and other forms of mental distress, it’s better to tackle your debt first before investing. Such a move might be better for your overall quality of life, even if it doesn’t make sense mathematically.

You might also feel more calm and confident once you establish a debt relief strategy or start working with a credit counselor on a more tailored plan.

» MORE: How to manage your money

You should invest if…

Here are some scenarios where it might make more sense to direct excess funds toward investing rather than paying off debts.

You have affordable, low-interest debt

If your debt is manageable and you have an emergency fund saved, you’re ready to start investing.

If all of your debts have single-digit interest rates and you’re able to afford the minimum payments, it might make sense to start investing. Just like debt interest, investments will compound over time, so the earlier you can start, the better.

» MORE: What is a good investment?

You have an emergency savings fund

Before you start investing, be sure you have at least six months’ worth of living expenses stashed away in case of emergency. Some experts say that three months is OK if you have a job that offers severance.

But an emergency fund isn’t just for job loss — it can also cover surprise auto repairs, medical bills, rent hikes and more of life’s unpleasant surprises. Plus, you can generate risk-free interest from your emergency fund if you stash it in a high-yield savings account.

You’re offered low-risk options like 401(k) matching

If you’re already working down debt, the prospect of starting an investment strategy may seem daunting. Luckily, starting off on the right investing foot can involve minimal effort and negligible risk.

“Take advantage of lower hanging opportunities that could be available to you,” said Christopher Stroup, a certified financial planner with Abacus Wealth Partners. “For example, if your employer offers a 401(k) match, invest just enough to maximize this match.”

» MORE: What is an IRA?

You should do both if…

Paying off debt and investing doesn’t have to be mutually exclusive. In fact, many experts agree that doing both at the same time is the ideal approach.

“Paying off debt in the present while still investing allows you to shore up your financial position while building a solid foundation for your future,” said Stroup. “Time is one of the biggest components to successful investing, which is why it's important to start early, even if that means contributing small amounts at first while you prioritize paying down debt.”

That said, this doesn’t necessarily mean you should go ahead and split your excess budget 50-50 across your debts and investments. In general, it’s best to meet two critical milestones before you begin to strike a balance: You have an emergency fund and a debt relief strategy.

Let’s say you have $2,500 in credit card debt, $20,000 in other forms of nonmortgage debt under 10% annual percentage rate (APR) and a small amount in investments. After expenses, you have $2,000 in excess funds to pour into one of three buckets: debts, investments and your emergency fund.

Here’s one sample approach you might take:

1. Wipe out your credit card debt. Chances are the interest rate is astronomical (20% or more), so you’ll want to dedicate the next two months to clearing your credit card debt. Alternatively, you can move your credit card debt onto a balance transfer card to buy yourself up to 21 months to pay it off at 0% APR. Just keep in mind that the typical balance transfer fee is 3%.
2. Establish your emergency fund. If your monthly expenses amount to $3,000, it might be best to spend the next three months filling up that emergency fund so you’ll be better prepared as you start paying off debts and investing.
3. Find the right debt relief strategy. You might set up a debt snowball, debt avalanche or an alternative strategy recommended by your credit counselor or financial advisor. Setting up a debt relief strategy can reveal exactly how much you can safely invest each month while still marching toward becoming totally debt-free.
4. Start investing. Take advantage of options like 401(k) matching at work. Once your emergency fund is full and your debt relief strategy is on track, you can safely start investing whatever’s left.

Again, this is just a sample that won’t work for everyone. To strike the right balance between debt payoff and investing, it’s best to consult a personal finance professional like a certified credit counselor, financial advisor or financial planner.

Bottom line

Generally speaking, it’s better to pay off debt first if you have high-interest debt, need to improve your credit or DTI ratio or your debt is simply causing you too much stress. On the flip side, it’s better to invest if you have your debt under control, an emergency fund in place and have yet to take advantage of options like employer 401(k) matching.

But all things considered, it’s best to do both. As soon as you have your high-interest debts either cleared or consolidated, a strategy for your remaining debt and an emergency fund ready, you can start simultaneously paying down your debts and investing at a rate that works best for you.