One of the biggest financial dilemmas people face is deciding whether to pay off debt or invest. The right answer depends on several factors, but a good rule of thumb is to focus on paying off any debt with an interest rate above 4% before prioritizing investing.
Why 4%?
The reason 4% is a critical threshold is simple: it’s a reasonable long-term assumption for the after-tax return of a conservative investment portfolio. If your debt carries an interest rate higher than 4%, paying it off is essentially a risk-free return that likely exceeds what you could earn in the market.
Conversely, debt below 4%—such as a mortgage with a 3% interest rate—should generally not be rushed to pay off because your dollars may be better put to work in investments with higher expected returns.
High-Interest Debt: A No-Brainer
If you have credit card balances, personal loans, or private student loans with rates of 6%, 8%, or even higher, these should be your top priority. No investment portfolio can consistently deliver risk-free returns at those levels. Paying off high-interest debt is a guaranteed win—it frees up cash flow, reduces financial stress, and strengthens your financial foundation.
Example:
- Credit card balance: $10,000 at 18%
- Minimum payment: $200 per month
- Time to pay off: Over 15 years, with $9,000+ in interest
By aggressively paying off that balance instead of investing, you immediately improve your financial position without taking on market risk.
The Middle Ground: Debt Between 4% and 7%
Debt with interest rates in this range—like many student loans or car loans—should be evaluated carefully. If your employer offers a 401(k) match, you should contribute enough to get the free match before aggressively paying off this type of debt. But beyond that, accelerating repayment of these loans is usually a better move than investing.
Example:
- Student loan balance: $30,000 at 5.5% interest
- Monthly payment: $300
- Extra payment of $500 per month: Loan paid off in 3 years instead of 10, saving thousands in interest
This approach balances financial progress with minimizing risk.
When Investing Makes More Sense
If your only debt is a mortgage under 4% or a federal student loan at 3.5%, the case for investing becomes stronger. The stock market has historically returned around 7-10% annually, and while there’s volatility, long-term investing usually outpaces the cost of low-interest debt.
If you have extra cash, investing in a diversified portfolio, maxing out tax-advantaged accounts, or even putting money into income-generating assets like real estate can yield better results than paying off ultra-low-interest debt.
Final Thoughts
If you have debt above 4%, focus on paying it off before investing heavily. Once high-interest debt is gone, shift toward a balanced approach that includes investing while handling low-cost debt strategically. The key is to make decisions based on math, risk tolerance, and long-term financial goals.
Still unsure?
Reach out to one of our financial advisors who can help you weigh the trade-offs and create a plan that fits your unique situation.