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You Just Got a Raise: Do You Pay Off Debt or Invest?

Savvy women know it’s important to both invest for retirement and pay down debt. They know that earlier is better when it comes to investing but high-interest debt can constrain your ability to invest. So, when that hard-earned raise or unexpected bonus lands in your bank account, what’s the financially responsible thing to do? Should you make additional debt payments or invest the money?

It depends. Balancing the need to save with the need to reduce debt can be tricky. It depends on many factors, so assessing your individual situation is an important first step. Consider how much and what kind of debt you have, the interest rate(s) on the debt, how much you have already saved, the expected return on an investment, your income, age, tax situation and credit score.

However, before we explore which option may be better for you, let’s address the “emergency fund,” which many people lack. In fact, a recent survey by Bankrate.com found that 63% of Americans have less than $500 in emergency savings. As a general rule, you should ideally have three to six months of living expenses saved in case of an unexpected job loss or illness. If you don’t have that much saved, then building up your reserves should be your first priority.

Decision A: Make More Debt Payments

First, remember that not all debt is necessarily bad. Some debt could be considered an investment, such as a mortgage, student loan or business loan. Debt also varies in terms of the interest rate it carries and whether it has tax advantages. Interest paid on mortgages, subject to certain restrictions, and business loans are generally tax deductible. Interest up to $2,500 on student loans is deductible each year as long as income guidelines are met. These debts generally have low interest rates, and the interest deductibility makes those rates even lower.

However, reducing a credit card balance with a high interest rate should be a priority. According to CNBC, the average household in the U.S. carries just over $16,800 in credit card debt and the average credit card interest rate, according to Creditcards.com, is around 16.7% (over 23% if you have bad credit). That’s over $2,000 in interest each year, assuming the balance remains constant.

Reducing debt may also be a better option if you need to improve your credit score. A low credit score could inhibit your ability to borrow and will likely result in paying higher rates.

Decision B: Invest in Your Retirement While Carrying Debt

The reasons to invest in your future first before paying off debts are worth considering, especially if you think you can earn more on an investment than you are paying in interest on your debt. The average annual return for the stock market (as measured by the S&P 500 Index) over the past 50 years has been approximately 10%, but that is an average and not a return that investors can expect in every year. Even so, if your debt has a very low interest rate, it may be worth continuing to hold the debt while investing the extra money.

Another consideration is your age. The younger you are, the more you could benefit from the compounding aspect of investing. Compounding is when the interest on your investment earns interest and growth becomes exponential. For example, if you invested $1,000 at a compound annual interest rate of 10%, you would have almost $2,600 in ten years without doing anything else.

Further, if your employer matches any of your 401(k) contributions, make sure you take advantage of this. Many employers match your contribution up to 6% of your salary. It may boost your enthusiasm if you view the match as a guaranteed 50% return on the first 6% of your contribution. There are also tax advantages to investing in your 401(k) as that money is contributed tax-free and reduces your taxable income.

Decision C: Increase Debt Payments AND Your Retirement Investment

Many people don’t like to carry debt, no matter how low the interest rate. If that’s you, you may want to split your extra money to increase your debt payment each month while also increasing the amount saved for retirement. The impact won’t be as significant on either your debt status or your retirement outlook, but both will be moving in the right direction.

When it comes down to your individual situation, there is no “right” decision. The important thing is to get your money working for you as efficiently as possible while also prioritizing what’s important to you.

The Financial Advisors at Jemma understand that your life goals sometimes experience a detour. We are here to help you with these and other money and investing questions whenever you are ready. Contact us today for a complimentary consultation.

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