Welcome to the “2-Minute Money Manager,” a short video feature answering money questions submitted by readers and viewers.
Today’s question is about debt; specifically, whether it’s better to pay off all your debt before you begin investing.
Watch the following video, and you’ll pick up some valuable info. Or, if you prefer, scroll down to read the full transcript and find out what I said.
You also can learn how to send in a question of your own below.
For more information, check out “7 Great Tools for Killing Off Your Debt — and Saving” and “9 Tips for Sane and Successful Stock Investing.” You can also go to the search at the top of this page, put in the words “investing” or “debt” and find plenty of information on just about everything relating to these topics.
Got a question of your own to ask? Scroll down past the transcript.
Don’t want to watch? Here’s what I said in the video
Hello, and welcome to your “2-Minute Money Manager.” I’m your host, Stacy Johnson, and this answer is brought to you by Money Talks News, serving up the best in personal finance news and advice since 1991.
Today’s question comes from Sonia:
“I’ve heard you should pay off your debt before you start investing. Is this always true? If so, what about a mortgage? Should we pay that off before buying stocks?”
Sonia, to answer this question, let’s consider both the type of debt and the type of investing.
The type of debt
If you’re talking about credit card debt, the answer is obvious.
If you’re paying 18% interest on a credit card, paying it off is like earning 18%, risk-free and tax-free. There’s no investment that good, so you’ll get your biggest bang for your buck by paying off the plastic.
Paying off any high-interest debt before investing is the rule. But as with most rules, there’s an exception.
Many 401(k)s and other types of retirement plans offer a company match. In these plans, your employer matches your contributions up to a certain amount, typically 50% of whatever you contribute, capped at 6% of your annual salary. So, if you earn $50,000 annually and contribute $3,000 (6%) to your retirement plan, the company will contribute $1,500.
That’s like earning a risk-free return on your investment of 50%.
So, if your company matches your 401(k) contributions, make sure you’re contributing enough to get every free penny being offered by your plan. After that, put any extra income you have left into paying off that high-interest debt. Once that debt is dust, you can start contributing more to your 401(k) — or looking into other investment options.
What about mortgage debt?
Mortgages are different from other types of debt for three reasons:
- First, their interest rates are typically much lower. While not guaranteed, it’s definitely possible to earn more investing than you’re paying in mortgage interest.
- Second, depending on your tax situation, mortgage interest can be deductible, which effectively makes the rate even lower.
- Finally, mortgages last a long time. I’m never going to tell anyone to wait 30 years to start investing.
The bottom line
When you can scratch up some extra scratch, here’s the order: First, make sure you’ve got an emergency fund so you don’t have to borrow if something goes awry. Next, make sure you’re getting any free matching money your company is willing to cough up.
Got that working? Pay off that plastic or other high-interest debt.
Got all that done? Do some investing, and try to pay extra on that mortgage every month so you destroy that debt as soon as possible. Let a few decades go by and next thing you know, you’re rich!
Hope that answers your question, Sonia! Now, if you’re watching me on YouTube, click the subscribe button below. If you’re watching me at Money Talks News, sign up for my free, awesome newsletter: Click the “newsletter” button in the nav bar above. I’m Stacy Johnson, and I’ll see you all next time!
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I founded Money Talks News in 1991. I’m a CPA, and I’ve also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.
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