Investment guide

Should I invest or pay off debt?

Deal with debt or invest your money? When managing our finances, we are often faced with the dilemma of whether to invest any extra money we might have or use it to pay off debt (or at least substantially pay it down).

Both options have their merits and can contribute to your long-term financial well-being. However, the decision ultimately depends on individual circumstances, risk appetite, and financial goals.

So, in your circumstances is it better to invest or pay off debt? In this article, we’ll explore the pros and cons of investing and paying off debt, to help you to decide which is best for you.

The case for investing: growing your wealth

Investing is the process of purchasing or placing your money in various financial assets, such as shares, bonds, exchange traded funds (ETFs) or managed funds, intending to generate returns over time.

Key benefits of investing include:

Compounding returns: Compound returns are when your investment returns are invested to earn their own returns, a powerful effect that sees your money grow faster over time.
Diversification: By spreading your assets across different investment options, you can reduce the risk of significant losses by protecting your wealth against market fluctuations – while the value of some assets might decrease, others may increase.
Retirement planning: Investing is an essential component of retirement planning. By starting early and making regular payments to retirement accounts like KiwiSaver, you can build a nest egg that provides financial security in later life.

But investing also carries certain risks:

Market volatility: Investments are subject to market fluctuations and can experience ups and downs. Market volatility can be unsettling, sometimes causing investors to make hasty decisions which could result in losses. Investing requires patience and a long-term perspective.
Returns are not guaranteed: All investments come with some degree of risk. There’s no guarantee of generating a return when you invest your money, and there is a risk that you lose that money. It's important to assess your risk appetite and choose an investment strategy that aligns with your comfort level.

The case for paying off debt: achieving financial freedom

Rather than invest your available funds, you could choose to reduce or pay off outstanding debts, such as credit card balances, personal loans, student loans or mortgages.

Advantages of prioritising debt repayment include:

Financial freedom: Paying off debt can free you from financial burdens, reduce stress and improve your financial well-being, including your credit score. It gives you greater control over your money, which you can then use for other financial goals.
Interest savings: By paying off high-interest debts, such as credit card debt, you can save serious money in the long run, freeing up funds that you can spend or invest instead.
Reduced risk: Being debt-free reduces your financial vulnerability. When unexpected events arise, like losing your job, medical emergencies or economic downturns (like a recession), you won't have debt obligations to meet alongside these extra living costs.

But consider these factors before prioritising debt repayment:

Opportunity cost: By using your money to pay off debt, you may miss out on potential investment returns. If your debts have relatively low-interest rates, such as a home loan, investing your available funds may provide better returns in the long run.
Emergency fund: Before focusing solely on debt repayment, consider creating an emergency fund – savings that are set aside in an accessible, high-interest bank account to protect you from unexpected expenses that could push you further into debt.
Balance transfer or refinancing options: Explore options for reducing your debt burden, such as credit card balance transfers to a lower interest rate, or refinancing loans. These strategies can help optimise your debt repayment while still allowing you to invest.

Making the decision: investing vs paying off debt considerations

Ultimately, the choice between investing and paying off debt depends on your unique circumstances.

Pay off mortgage or invest?

A mortgage is the largest and lowest-interest loan that most people can take out. This makes your home loan a unique case in the decision to pay off debt or invest.

In a high-interest environment, you’ll face larger interest payments on your mortgage, so you may decide that it’s best to pay your home loan down. But that same high-interest environment will also allow you to earn more from a high-interest investment, granting you the ability to grow your wealth, and giving you access to that money should you need it.

Ultimately the return rate of any investment needs to be higher than the interest rate of your home loan for it to make financial sense. Beyond that consideration, it’s up to you to decide whether dealing with debt or investing should be your priority.

Other paying off debt vs investing considerations include:

Interest rates: Compare the interest rates on your debts with the potential returns on your investments. If the interest rates on your debts are high, it may be more beneficial to prioritise debt repayment.
Timeframes: Evaluate your financial goals and the time you have available to achieve them. Investing is ideal for long-term goals, while paying off high-interest debt can offer immediate benefits.
Risk appetite: It’s important to assess your risk appetite, also known as risk tolerance. This is how comfortable you are seeing market fluctuations potentially affect your investment balance. Investing carries risks, while paying off debt provides a sense of financial security.
Strike a balance: Why not invest and pay off debt? Allocate a portion of your available funds to both, to make progress on debt repayments while also benefiting from long-term investment growth.

Whether to invest or pay off debt is a complex decision that requires careful consideration. While investing may offer growth potential and long-term financial security, paying off debt provides immediate relief and reduces financial vulnerability.

Remember, financial decisions should align with your goals, risk tolerance, and the path to a secure financial future. Finding the right balance is crucial, so it's wise to seek guidance from financial professionals who can provide advice based on your specific circumstances.

Need help with investing?

Knowing where to start with investing can be challenging. Because everyone's needs are different – there's no one size fits all. At AMP, we offer a range of investment options that may suit you. It’s a good idea to seek financial advice or other professional advice relevant to your personal financial situation. We recommend you contact your Adviser, or, if you don’t have an Adviser, contact us on 0800 267 5494.