Is it better to invest or pay off debt?

There is a definitive answer to the debate between investing and paying off debt. (iStock)

The answer to this question, "is it better to invest or pay off debt?” is deceptively simple: you should only invest before paying the debt if you can earn more on your investment than you’d pay in interest on your debt.

And to be clear, this rarely happens, because debt is so expensive. The average interest rate on credit card debt is around 21 percent, while the stock market only returns an average between 5-7 percent year over year.

There are, of course, exceptions. In particular, there are two other instances where it may make better financial sense to invest rather than aggressively pay off debt.

Paying down your mortgage

Since 2012, mortgage rates have been at historic lows. Currently, the average mortgage interest rate sits somewhere between 3-4 percent. For this reason, if the only debt you have left is your mortgage, it doesn’t make sense to pay this down.

Because the stock market typically earns an average rate of return of around 7 percent each year, this means you’ll likely earn more on the markets than you will by aggressively paying down your mortgage. Again, stock market returns aren’t guaranteed and your mortgage interest rate depends on a lot of things such as your credit score.

CALCULATE YOUR DEBT-TO-INCOME RATIO AND FIND OUT WHERE YOU STAND

But, if you annualize the average stock market rate of return over 30 years, via the magic of compound interest, it’s really more lucrative to invest because time is on your side.

Low-interest student loans

Student loan debt can also be at a lower interest rate than what you stand to earn investing. Even with the lower interest rates, however, it may make more sense to pay off student loans if your monthly payment is high and you’d like to free up that cash for other savings goals like buying a home, retirement, or building an emergency fund.

Can you invest and pay off debt at the same time?

Yes, you can, but there’s really only one situation where it makes sense to do both. If your company provides a 401k match on any contributions you make to your retirement plan, then this is when you should make investment contributions a priority while paying down debt.

The 401(k) Match

Saving for retirement is investing because those “savings” are going into an investment vehicle (the 401k). If you don’t contribute enough to get the match from your employer, it’s as if you’re allowing your employer to get away with paying you less. Don’t forget - any 401k match contributions are factored into the total compensation package they give you when you start your employment.

WHY YOU SHOULD NEVER BORROW FROM YOUR 401(K) TO PAY OFF DEBT

For example, your company offers a 5 percent match on 401k contributions if you put in 4 percent of your $50,000 salary. At the end of the year, this is 9 percent total into an investment vehicle on your behalf. Sure, you’re putting in $2,000 that could go to debt repayment, but you’ll receive $2,500 for doing so, and this money will compound and grow over time, making it worth far more in the long term than in the short term if you use that money to make larger debt payments.

Are there any other exceptions?

Without looking at investment returns or your own financial goals and priorities, the fast answer to “is it better to invest or pay off debt?” is to pay off debt. Every time.

HOW DOES DEBT CONSOLIDATION AFFECT YOUR CREDIT SCORE?

If you’re dying to start investing, use that as motivation to aggressively pay down your debt. The earlier you become debt-free, the earlier you can start investing and the more cash you’ll have available to allocate to growing your money. The sooner you start investing, the more time you have for those investments to grow into true wealth.