Pay off debt or invest is a typical question that many of us ask ourselves. This question pops-up even more now that interest rates at saving accounts are at historical lows.
It’s just painful to see your money being eaten up by inflation!
Hence, let’s put that money to work and build some wealth.
But where to start?
That’s the question I will answer today by providing you 4 simple steps that should leave your financial worries behind forever.
But before we start, I wanted to let you know that this is my general wealth creating rule-of-thumb:
Pay off all high-interest debts first, before creating an emergency fund, before investing.
I realize that this is a very simple recommendation and that it might not provide you with enough confidence that this is the wisest thing to do.
So let’s get started.
1. Pay off High Interest bearing debt first
Should i pay off student loans or invest? Pay off mortgage or invest? Should you pay off car loan or invest? Or should I pay off my credit cards first or invest?
These are really some of the questions in our heads.
To answer those questions, I would recommend you to do a similar calculation as below:
Imagine having credit card debt with a yearly interest rate of 14%.
Every 100 Euro paid down on that credit card will directly earn you 14 Euro in lower yearly expenses.
If you would add that same 100 Euro to your savings account instead, then you will likely not even get 1 Euro of interest paid on your savings account.
You are losing money if you are paying more interest on your debt than you’re earning in interest from your savings account.
Having such high interest expenses on debt also justifies paying it off with utmost urgency.
You shouldn’t worry yet about future unforeseen expenses or whatever else might happen. The worst that could happen in such situation is to increase your credit card debt again 😉
Personally, I consider any debt which is more than 4% as high-interest debt. At least too high for such a low-interest environment.
My recommendation therefore is to pay off all your high-interest debt first. Typical examples of such debt are:
- credit card debt,
- car loan(s)
- running line(s) of credit
What about paying off low-interest debt?
Paying off low-interest debt first becomes an opportunity cost question. Some people prefer to be totally debt free and if you are such person then you should definitely consider to pay it off all.
Don’t listen to what others say.
Many people would quickly tell you that you can earn an 8% return on that same money when investing it in the stock market.
Don’t let yourself get distracted with that. You are accountable for your own wealth and it’s up to you to decide about your level of comfort.
2. Build your Emergency Fund
After paying off all high-interest debt it’s time to build an emergency fund.
An emergency fund is a reservation of cash to support you in any unforeseen events.
The expenses related to such an event are typically large and difficult to cover from your monthly salary.
Just consider some of the following events which might happen to any of us:
- Loss of income due to job loss
- Leakage of your roof, car damage
As a rule of thumb it is recommended to reserve up to 3 – 6 months of cash.
Whether you should consider the low-end or the high-end of that range really depends on your appetite for risk.
I’ve personally built an emergency fund towards the 6 months. We have a large house and the potential expenses related to it could be very high.
I can imagine that you would rather chose the lower end of that range. If you have nobody really to provide for or if you don’t own any physical assets that the financial impact of such an event might be lower.
Is your debt under control and is your Emergency Fund created?
This is typically where you start to experience for the first time a little bit what financial freedom truly means.
Hence, be very proud on yourself and don’t forget to celebrate this.
By now you have already achieved something very remarkable: you created peace in your mind
And the best of this all: you can stop looking backwards and start focusing on the future.
By now you will have income left that you can actually start investing.
If you are like me, you might actually notice that your mind starts shifting from a scarcity mindset into a mindset of abundance.
This is truly a great position to be in, so let’s have a look now at what we can do with your disposable income after having paid all your fixed and monthly expenses.
This is also the moment where I would like to start the topic of what to do with your mortgage.
3. Get your mortgage under control
Should I further pay off my mortgage or shall I start investing?
First off all I would recommend to have your monthly mortgage expense to be not more than 28% of your monthly income.
This is considered a maximum threshold that sets you up to be able to handle many unforeseen events like:
- increasing interest rates
- increase of other expenses (i.e. getting a child)
Hence, to get your mortgage under control I would recommend to pay off this debt until you get below the 28% threshold.
Anything additional is up to your own personal preference.
Pay off mortgage fully or invest?
Let’s assume now that you have your monthly mortgage expense under control.
Should you now continue paying down the principal of your mortgage or invest?
The answer to this question is not an easy one and very personal.
In my opinion it is about the topic of your own appetite for risk.
However, the economic case will probably justify to start investing now.
If the stock market historically returned 10% per year and your mortgage is about 4% then it sounds like a no-brainer and start purely investing.
From the other side, being focused on reducing all of your debt first before starting to invest will further lower your fixed monthly expenses.
This would mean even more peace in mind and it has also two other potential benefits:
- It gives you more freedom in mind and life to make choices that align closer to your passion. I.e. change a job in the corporate world to an NGO and find more purpose in how you spend your time while working.
- It allows you to go more mad on your investments afterwards, because being debt-free provides you more investable income. There’s less risk and less guilt, because in the case you lose a part of your investment, you might regret not having used that money to pay-down your mortgage.
So to summarize, both investing or paying down mortgage can logically be justified, but it rather depends, again, on your appetite for risk.
4. Invest your money in appreciating assets
This is the phase where you can really start fueling your wealth.
I will not be able to recommend you something here and I would suggest to build your own plan. Maybe a financial advisor can help you here?
I have personally chosen to invest in dividend growth companies.
But there is so much more out there!
Just look at some of these examples:
- Real Estate property investing
- Investing in Exchange Traded index Funds (ETF’s)
- Individual Stock investing
- Investing in bonds
And you don’t need to pick just one of these. You can also chose for a combination of these.
That would actually be a good recommendation, because diversification might lower your risk profile.
What have I done personally?
The only debt that I have left is approximately 33% of mortgage based on the value of our house and 15% of my monthly income.
It is my aim to slowly, but steadily pay off the mortgage so that we aren’t confronted with another 21 years of debt, but rather say 12 years.
I would really like to not having to include my monthly mortgage payment in my expense calculation when becoming financially independent.
However, I do use a combination of investment and mortgage down-payments.
My first focus is on investing approx. 50% of my salary into my dividend growth portfolio.
After that, any savings above that rate will go directly to paying off the mortgage.
I haven’t calculated yet how quickly it would allow me to pay down the mortgage, but I’m pretty sure that the impact will already be visible after a few years.
Following these 4 simple steps to paying off debt first before investing should really elevate your wealth.
After this you will be in such a luxury position to make financial decisions that can really boost you wealth and change your life forever.
I hope that you found this article helpful and applicable to your own personal situation 🙏
In any case, feel free to get in touch with me or to drop an comment and I will try to get back to you as soon as possible.