Should You Pay Off Debt or Invest? A Smart Financial Strategy

When it comes to managing your finances, one of the most discussed topics on birthdays is whether you should pay off debt first or start investing. While both options have their advantages, making the right decision depends on your financial situation, risk tolerance, and long-term goals. Let's dive into the pros and cons of each approach to help you make an informed decision.

Why Paying Off Debt Should Be a Priority

1. High-Interest Debt is a Financial Anchor

If you have high-interest debt, especially credit card balances, paying it off should be your top priority. This is mostly applicable in the US. In Europe it is much less common to have creditcard debt, but peer-2-peer loans, or companies like Klarna (Pay later) are causing some people to come into high interest debt.

Many of these type of debt carry high interest rates or more, which can quickly spiral out of control. Even if you invest in the stock market and earn an average annual return of 7-10%, you’re still losing money if you're carrying high-interest debt.

2. Debt Can Be a Mental and Emotional Burden

Beyond the financial aspect, debt affects your mental state. Studies show that high levels of debt contribute to stress, anxiety, and even depression. The constant worry about monthly payments can take a toll on your well-being and limit your ability to make sound financial decisions. Being debt-free provides peace of mind and a sense of financial security.

We, ourselves, are actually using quite a lot of debt, but only for assets. Only our car is our exception (Yes, most likely not our best financial choice).

Read here how we use private money loans to invest

3. The Dave Ramsey Approach

Internet personality and Financial expert Dave Ramsey is a strong advocate for eliminating debt before focusing on investments. His "Baby Steps" method emphasizes paying off all non-mortgage debt using the debt snowball strategy—paying off the smallest debts first for quick psychological wins, then moving on to larger ones. According to Ramsey, once you're debt-free (except for a mortgage), you can aggressively build wealth through investing. Even thought I don't agree with Dave Ramseys investment tips (mostly mutual funds advise) he is very effective when it comes to getting out of debt. And getting out of debt is the first step to getting "free".

See why we prefer ETF's over Mutual funds.

The Case for Investing First

While paying off debt is crucial, there are instances where investing early makes sense (mathematically) .

1. Investing Offers Higher Long-Term Returns

The stock market has historically provided an average annual return of 7-10%. If your debt carries a lower interest rate (such as a student loan at 4-5%), it can make financial sense to invest rather than aggressively pay off that debt. But when you don't own a house and in your country your student debt is causing you to be able to borrow less, or again higher rate, please consider paying your student debt first.

2. Compound Interest Works in Your Favor

The earlier you start investing, the more time your money has to grow through compound interest. For example, if you invest $500 per month at an 8% return starting at age 25, you could accumulate over $1 million by retirement. Waiting until you pay off all debt might delay your investment timeline, reducing your potential long-term gains. Personally we found this argument not very strong. When you focus on repaying the debt and therefore lower the monthly costs, you will be able to make up for the difference very fast and in the long run you will be able to invest even more.

3. Employer 401(k) Matches Are Free Money

If your employer offers a 401(k) match, you should at least contribute enough to get the full match. This is essentially free money, and missing out on it is like leaving part of your salary on the table. We 100% agree with this. Depending on your debt and the percentage of interest, we would consider investing in your 401k immediatly when you can, when your employer matches it.

But this part is very American. In the Netherlands for example we don't have this system. All employees have a mandatory pension plan. Every employee and employer pay an X percentage of your salary to a pension fund, which invest this for you. Much better for most of the people, because it is mandatory and you can not touch it till your pension date, and the majority of the people would touch it too much or not contribute enough.

Finding the Right Balance: A Hybrid Approach

Like with everything in life a balanced approach would be the best fit, in this case one that prioritizes high-interest debt repayment while still making smart investments.

1. Pay off high-interest debt first (anything above 6%).

2. Continue making minimum payments on lower-interest debt (such as student loans or mortgages) while investing in retirement accounts and taking advantage of employer matches.

3. Once high-interest debt is gone, increase your investments and work toward long-term wealth-building.

   
   

The Psychological Shift: How Paying Off Debt Sets You Up for Success

Being debt-free changes your financial mindset. Without debt payments hanging over you, you can allocate more money toward investments and take advantage of market opportunities. You'll also have greater flexibility to pursue career changes, start a business, or invest in assets that generate long-term wealth.

What’s Right for You?

What’s your approach? Are you focused on paying off debt, investing, or both? Share your thoughts in the comments!