Should I invest or save? Pay down my mortgage or invest? How much should I put into my Robinhood account versus my employer-sponsored 401(k)? When is it smart to do one or the other – or both?
Of course, some of these questions are situational; if you rent, you probably don’t have a mortgage; and if you freelance, an employer-sponsored 401(k) is definitionally out of the question. Moreover, what works for one person’s finances won’t work for everyone else (that’s why it’s called “personal finance”).
But whether you’ve come into a sudden windfall, are anticipating a solid raise, or are working on bettering your spending habits, answers to these questions do exist. Today, we’re going to explore when it’s wise to consider one side versus the other – or even both – in your investing versus ___ situations.
If you have debt, you’re not alone – currently, total U.S. consumer debt sits in the ballpark of $14.9 trillion, including home, car, and student loans, as well as credit card debt. Moreover, more than 191 million Americans have credit cards averaging $5,300 in debt.
Debt, by definition, eats away at your value through interest, fees, and a lowered credit score. Credit card debt can be particularly heinous, as the minimum monthly payment often doesn’t cover the 15-25% interest, leaving you in the hole while still technically meeting your obligation.
On the other hand, investing is designed to increase your value over time. This happens through compounding, as well as price fluctuations that, historically, trend higher through the years.
So, knowing this, when should you pay off your debt versus invest, and vice versa?
Paying down your debt first often makes sense, especially if you’re restructuring an existing budget. Consider:
While you shouldn’t skimp on your debts entirely, there’s also a case to be made for focusing more intensely on your portfolio. For instance, if you:
Of course, no one said that you had to choose one or the other. In fact, the general rule of thumb is that you should both pay your debts and invest, unless you’re in a particularly strenuous situation. You might consider contributing to three buckets at once: debt, retirement, and an emergency savings fund.
Even if you only put in $15 a month toward your savings and retirements, more often than not, that’s better than nothing. That’s said, how you balance your budget is important – if you overcommit to investing, you might wind up paying excessive interest over time. But if you neglect investing entirely, you’re more likely to miss your retirement goals.
Of course, not all debts are inherently “bad” – some are considered “good” debts.
One of the biggest differences is that paying down many debts, such as credit card loans and personal loans, leaves you with nothing but a paid-off loan and groceries. But with a mortgage, or other debts like student loans, you’re left with an investment in your future. In this case, a house.
That said, this does raise an interesting question: is the house you live in an investment?
After all, it’s not a rental property – you’re not bringing in monthly income or writing expenses off on your taxes. Moreover, a house comes with extra responsibilities, such as property taxes and insurance. And while the housing market might boom and you make a pretty penny selling out for greener pastures, it might also go bust and leave you holding the bag on a mortgage that outpaces the actual cost of your home.
In this debate, it comes down to personal preference, as well as your lifestyle. Renting is usually cheaper overall, and typically comes with less responsibility and the freedom to move more frequently and easily. That said, you’re also subject to the whims of your landlord, rising prices, and the risk that your building may suddenly go condo.
And of course, you’re not building equity as a renter – which brings us back to our actual question: is it better to invest or pay off your mortgage?
To answer this question, let’s start with a math problem. Would it make more sense to pay an extra $300 per month toward your mortgage, or invest that $300 per month while making the minimum mortgage payment?
Let’s assume that you take out a $400,000 mortgage at 4% interest for 30 years. (For the sake of simplicity, we’re not including mortgage or home insurance or property taxes.) In that period, you would pay $1,910 per month for a total of $687,500 – almost $288,000 of that in interest.
However, if you paid an extra $300 per month for the life of the loan, or $2,210 per month, not only would you pay down your home seven years early, but you would cut your final payment to $614,100 – savings of almost $73,400.
On the other hand, let’s say that you stick with your original mortgage plan and instead invest that $300 per month into the stock market at 10% annual returns for 23 years. (The amount of time it would take you to pay off your home with extra payments.)
In that time, your investments would grow to over $322,600 – roughly $83,000 from your contributions, and the other $240,000 as return on your investments. In other words, your portfolio would grow to almost five times as much as you would have saved in interest. At this point, you could use your investment funds to shave that last seven years off your mortgage anyway with room to spare.
Moreover, if you invested these funds in a retirement account with employer matching, rather than a brokerage account, you could double your investment with “free money” over time and accelerate your earnings that much more.
The examples above illustrates how, financially, it may make more sense to invest rather than funnel extra cash toward your mortgage. But these numbers shouldn’t be your end-all to this equation.
For instance, consider that paying down your mortgage comes with hefty interest savings, especially if you have a high interest rate. (This is truer early on, as your initial payments go more toward your interest than your principal.)
At the same time, paying more on your mortgage means you’ll build equity in your house faster, which you can then use to qualify for refinancing down the road. Plus, the more you own in your home, the more you can leverage in a home equity line of credit (HELOC) loan, which can help pay for home improvements, large purchases, or other debts.
Once again, there’s a case to make for doing a bit of both – say, splitting that extra cash into $150 toward each.
For instance, mortgage interest payments are often tax-deductible, which can reduce the overall amount you owe Uncle Sam. As such, paying more in interest early on can lead to higher deductions while also building more equity in your home.
And at the same time, putting money into an investment account, especially a tax-advantaged retirement account, means that you can further reduce your tax liability while earning compounded returns for your future.
Another problem you may face as an investor is whether to invest or save up for the next emergency that comes your way. And while they may sound like the same strategy – after all, they both help you build a more comfortable financial future – the fact is, investing and saving are distinct in several ways:
But when it comes to restructuring your budget or allocating funds from a sudden windfall, which is better?
As it turns out, neither saving nor investing is better in all circumstances – and it all depends on where you start from.
For instance, if you don’t have a savings account set up, then piling money in a risk-free environment, even if it learns less interest, is one of the best moves you can make. Experts typically recommend that you have a minimum of 3-6 months’ worth of expenses saved in an emergencies-only account.
Where you save matters, too: emergency savings should be set aside in a highly liquid account, such as a traditional savings account, short-term CDs, or some money market accounts.
Note that you shouldn’t stop saving – even in your emergency fund – just because your bank account is fuller than it’s ever been. While it’s not as urgent to set aside money now, it never hurts to have a well-padded account with money spread across higher-interest environments such as high-yield savings accounts or long-term CDs. And the bigger your emergency fund, the better off you’ll be in case of job loss or other major events.
That said, once your emergency fund is well-funded, it’s time to start investing, too. Keep in mind the basic rules of thumb:
In general, investing is better for funds that need to grow more aggressively. And the longer your time horizon, the more time your funds will have to smooth out and recover from inevitable capital losses.
Of course, there’s one time it almost always makes sense to invest and save, regardless of your financial situation: when your employer offers 401(k) matches. Unless investing for retirement will make it impossible to pay your bills, it will pay later to start setting aside money now.
This is true even if you’re in the process of building your emergency fund. For instance, if you can afford to save $50 per month, it may make sense to contribute $25 to both your emergency savings account and your 401(k) – which will turn into $25 in your savings and $50 in your employer-matched retirement account. This kind of growth can really add up!
Once your emergency fund is well-padded and you’re maxing out your 401(k) matches every month, it’s time to consider investing more (assuming you have the funds left over). Keep in mind that you shouldn’t invest anything you can’t afford to lose, nor anything you need to pull out in a timely manner.
And this brings us to our last pivotal question: when should you consider investing in the stock market versus your 401(k)?
Like the previous questions, the answers are rather nuanced. To break it down in a moment:
But what if you aren’t comfortable enough to max out your contribution and invest on the side? Alternatively, what if you want to set aside money for something other than your eventual – and for some, far away – retirement?
At that point, it’s time to make a different set of decisions based on your lifestyle and goals.
For instance, consider your non-retirement plans. Investing in a 401(k) lets you plan for the future – in several decades. But if you want to buy a house in 15 years, or a new car in 10, investing some of your money in the stock market now may make more sense.
Furthermore, if you have reason to think that you’ll want (or need) some of that money before retirement, it might be worth stashing it in a high-yield savings account or the stock market to avoid the 10% tax penalty that comes with taking early withdrawals.
Like the other situations we’ve covered, there’s a case to be made for investing in both your 401(k) and the stock market. And in fact, even if you don’t get to max out your contribution, it may be the best move for your situation.
For instance, consider the rates of return on your investments. While every plan is different, on average, your 401(k) should return roughly 5-8% annually, assuming that you have an asset allocation of roughly 60% stocks and 40% debts and cash.
At the same time, the broader S&P 500 benchmark index has historically generated an average of 8-10% annual returns. And while it’s typically safer than equities investing, putting money into long-term government bonds has returned just 5-6% in comparable time frames.
As such, if you split your funds equally between your 401(k) and your brokerage account, on average you would earn just slightly less on your money in your retirement account – but over a potentially longer timeframe than your investment funds.
This would allow you to capitalize on some of your money now while still setting aside plenty for retirement later (and without incurring that hefty 10% tax penalty for early withdrawals).
Whether you want to pay down your debts, finish off your mortgage, or split your funds wisely between saving and investing in your future, it’s important to do what makes the most sense for you – and your pocketbook.
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