When you’re paying down a large debt like student loans, it can be hard to determine when it’s worth accelerating your efforts to get rid of that hefty balance. Should you put every extra dollar toward your loans, or should you focus on saving money?
It’s sort of a tortoise-and-hare scenario for your money. Go fast and furious, and you’ll get out of debt faster, but the rest of your finances could stagnate as a result. Go slow and steady and you might feel hopeless about that big debt, even though you may be better off in the long run.
But there’s a method for figuring out how to prioritise paying debt versus investing that takes away all the emotions and relies on numbers. Actually, just one number: your interest rate.
If your interest rate for your debt is lower than a conservative return on your portfolio, focus on investing. If your interest rate for your debt is higher than that conservative return, focus on paying off the debt.
That magic number depends on how prone to risk your investment portfolio is. But generally, you can expect a return of 6%-8% annually, once all the peaks and valleys are smoothed out.
So if you expect your portfolio to grow by 6% this year, and your loan interest rate is 8%, you probably want to focus on knocking out your debt and the interest that’s accruing more quickly than your portfolio is likely to grow.
Say you expect a 6% return and your interest rate for your student loans is 4%. Then it makes more sense to invest.
Want it to be even easier? Just focus on the number five. Some experts even call it the 5% Rule, according to Lifehacker alum Kristin Wong for the New York Times. Instead of thinking about your rate of return, you make 5% your breaking point to focus on debt versus investing.
When you break it down this way, it’s obvious why it’s so important to pay down consumer debt like credit cards—and why you don’t necessarily have to sweat your student loans as much. With a credit card, your debt can grow by as much as 30% each year, while your investments will only grow by something less than 10%. You’re losing money far faster than you’re earning it.
One caveat to keep in mind: This method works best for people who have investing portfolios beyond tax-advantaged accounts. If your employer offers a match for your retirement account, you should contribute even if your student loan interest rate is above 5%, notes Erin Lowry for Money. There’s no reason to turn down that free money.