Decide Whether to Pay Off Debt or Invest Using the 5% Rule
When you are paying off large debt, such as student loans, it can be difficult to determine when to step up your efforts to get rid of this imposing balance. Should you invest every extra penny in your loans or should you focus on saving money?
This is a kind of scenario with a turtle and a hare for your money. Go fast and furious and you will get out of debt faster, but as a result, the rest of your finances can stall. Act slowly and persistently, and you may feel hopeless about this big debt, even if you might get better in the long run.
But there is a method of prioritizing debt repayment over investing that takes all the emotion away and relies on numbers. Actually, just one number: your interest rate.
If your interest rate on your debt is below the conservative return on your portfolio , focus on investing. If your interest rate on your debt is higher than this conservative rate of return, focus on paying off the debt.
This magic number depends on how risky your investment portfolio is. But generally, you can expect 6-8% yields per year once all the peaks and valleys have been smoothed out.
So if you expect your portfolio to grow 6% this year and your student loan interest rate is 8%, you probably want to focus on paying off your debt and interest, which is accumulating faster than your portfolio, probably will increase.
Let’s say you are expecting a 6% return and your student loan interest rate is 4%. Then it makes sense to invest.
Want to make it even easier? Just focus on the number five. Some experts even call it the 5% rule , according to Lifehacker alumnus Christine Wong of the New York Times. Instead of thinking about profitability, you put 5% of your cap to focus on debt, not investment.
When you break it down this way, it becomes obvious why it is so important to pay off consumer debt like credit cards, and why you don’t have to worry so much about student loans. With a credit card, your debt can grow by 30% every year, while your investment will only grow by less than 10%. You are losing money much faster than you are making it.
One caveat to keep in mind: This method is best for people who have investment portfolios outside of tax-exempt accounts. “If your employer offers a match for your retirement account, you must contribute even if the student loan interest rate exceeds 5%,” notes Erin Lowry for Money . There is no reason to give up this free money.