Paying down debt and investing are great items to have on your financial ‘to-do’ list. Both will increase your net worth and accelerate your path to financial independence. But, which of these financial goals should get the first spot on your list? In order to determine the right plan for you here are a few key variables to consider. Let’s dive in!
Having debt puts you at financial risk
Paying off your debts can lift a huge burden of anxiety, fear and stress. But, a debt-free life without any savings is like teetering at the edge of a cliff. One gust of wind (i.e. an expensive surprise) and you’re tumbling back into the abyss. For most millennials, especially those living in expensive urban cities, it doesn’t take an actual emergency to be hit with large expenses that might require dipping into an emergency fund.
Deciding whether to pay off debt or invest
The logical course of action when deciding between paying off your debt or investing boils down to a comparison of two variables:
- The interest rate you’re paying on your debt.
- The rate of return you can expect to earn on your investments
On the one hand, if you reduce your debt, you guarantee yourself a rate of return equal to the interest rate that you’re avoiding. For example, paying off a $10,000 line of credit will “save” you from having to pay interest of 6%. And in effect you have “earned” a 6% rate of return.
On the other hand, if you set aside that money in savings instead, you would require a 6% rate of return from your investment to be in the same position as having paid down the debt, or breaking even.
Debt and investing are both risky, but in different ways.
There is one major distinction between the rate of return you can expect from paying off your debt versus the rate of return you can expect from an investment. The interest rate on your debt is guaranteed, whereas most investment products can’t promise any guarantees at all, and can potentially result in a loss.
So, if you’re carrying debt, and the thought of losing money keeps you up at night, there’s only one safe bet here and that’s putting debt repayment squarely at the top of your financial to-do list.
A financial framework that works
Investing is within reach if you take things one step at a time. Here’s the framework that we use at Paper & Coin to guide our community and clients on how to strategically reach their financial goals, one step at a time.
BUILD YOUR BOOSTER FUND
This is the starting point. Your Booster Fund is 1-month’s worth of ESSENTIAL living expenses set aside in case of an emergency. This money should be kept:
Liquid: meaning readily accessible
Safe: meaning not invested in anything that could result in a decrease in value.
PAY OFF YOUR DEBTS!
Next, start devoting as much of your financial efforts as possible to debt repayment. That means aiming to completely eliminate all debts that are within your control, as fast as possible.
During this time, you should also still aim to set aside a little bit of additional savings in your “Stuff Fund”. This is separate from your emergency fund, and it meant to be a temporary hold for cash that you’re setting aside for specific upcoming purchases like buying winter tires, for example. This is a key aspect to successful budgeting. You do NOT want to be relying on your credit card to make purchases while you’re trying to pay off that credit card, after all.
BUILD YOUR BUFFER FUND
Once you’ve completely paid off all of your open loans, your efforts should be redirected to saving up an additional 2-5 months of expenses to your Buffer Fund, a fully-fully emergency fund. That’s 3-6 months of living expenses set aside in a high-interest savings account. This is going to give you peace of mind and is absolutely essential before you move on to investing and building long-term wealth.
NOW, YOU’RE READY TO INVEST
Congrats! At this point you are debt-free, your Buffer Fund is fully loaded, and you now have the wiggle room in your budget to allocate towards investments and additional savings goals.
If you’re ready to get on a financial plan toward debt freedom, or establish a strategy to start investing, our Paper & Coin financial coaches are here to help. Prefer self-learning? Our Money Masterclass has two entire modules devoted to teaching you how to successfully and sustainably invest your money to build lasting wealth both now, and well into retirement.