Debt is a reality for many Australians, whether it’s a mortgage, credit card balance, or HECS. While paying off debt is often seen as the top financial priority, there are situations where investing your money instead can lead to greater long-term financial growth. The key is finding the right balance between reducing debt and building wealth.
This guide explores the factors to consider when deciding whether to pay off debt or invest, helping you make informed decisions that align with your financial goals.
Understanding the Trade-Off
The decision to pay off debt or invest comes down to opportunity cost—what you might gain or lose by choosing one option over the other. Paying off debt provides guaranteed savings in the form of reduced interest payments, while investing offers the potential for higher returns, albeit with some risk.
To make the best choice, you’ll need to evaluate your financial situation, the type of debt you have, and your investment opportunities.
When to Prioritise Paying Off Debt
Paying off debt should generally take precedence in the following situations:
- High-Interest Debt: Debt with high interest rates, such as credit card balances or payday loans, can quickly spiral out of control. The interest you’re paying on these debts is likely much higher than the returns you’d earn from investing.
- Example: If your credit card charges 20% interest annually and your investments are earning 8% per year, paying off the debt provides a better financial outcome.
- Variable Interest Rates: Debts with variable interest rates, such as some personal loans or mortgages, can become more expensive if interest rates rise. Paying off these debts reduces your exposure to rate increases.
- Financial Stress: If your debt is causing significant stress or impacting your mental health, prioritising repayment can provide peace of mind and improve your overall wellbeing.
- Lack of Emergency Savings: If you don’t have an emergency fund, focus on building one before investing. Having 3–6 months’ worth of living expenses saved can prevent you from relying on debt in the future.
- Close to Retirement: As you approach retirement, reducing debt becomes more important. Entering retirement with minimal debt ensures your fixed income or superannuation savings aren’t eroded by repayments.
When to Consider Investing Instead
Investing may be the better choice in the following scenarios:
- Low-Interest Debt: If your debt has a low interest rate, such as a mortgage or HECS, and you can earn higher returns through investing, it may make sense to prioritise investments.
- Example: If your mortgage interest rate is 4% and your investments are earning 7%, investing provides a net gain of 3%.
- Employer Super Contributions: In Australia, many employers offer superannuation contributions that match or exceed your own. Taking advantage of these contributions is essentially free money and should be prioritised over debt repayment.
- Long Investment Horizon: If you have a long time frame before you need to access your investments, you can take advantage of compound growth. Over decades, even modest returns can significantly outpace the cost of low-interest debt.
- Tax Benefits: Certain investments, such as shares or property, come with tax advantages that can enhance your returns. For example, franking credits on Australian shares or negative gearing on investment properties can make investing more attractive.
- Diversification of Wealth: Paying off debt is important, but it doesn’t build wealth. Investing allows you to grow your assets and create additional income streams, which can provide financial security in the long term.
Factors to Consider When Deciding
- Interest Rates: Compare the interest rate on your debt to the potential return on your investments. If the debt interest rate is higher, prioritise repayment. If the investment return is higher, consider investing.
- Risk Tolerance Investing involves risk, and returns are not guaranteed. If you’re risk-averse, paying off debt may provide greater peace of mind.
- Financial Goals: Your decision should align with your financial goals. For example, if you’re saving for a home deposit, paying off debt may take priority. If you’re building wealth for retirement, investing may be more appropriate.
- Cash Flow: Consider your ability to manage both debt repayments and investment contributions. If your cash flow is tight, focus on reducing debt to free up funds.
- Tax Implications: Some debts, such as investment property loans, are tax-deductible, which can make them less urgent to pay off. Consult a financial adviser to understand the tax implications of your debt and investments.
The Australian Context
In Australia, the decision to pay off debt or invest is influenced by factors such as interest rates, superannuation, and property market dynamics. Here’s how these factors play a role:
- Rising Interest Rates: With the Reserve Bank of Australia (RBA) increasing interest rates in recent years, variable-rate debts like mortgages have become more expensive. This makes paying off debt a higher priority for many Australians.
- Superannuation: Australia’s superannuation system provides a tax-effective way to save for retirement. Making additional contributions to your super can be a smart investment, especially if your employer offers matching contributions.
- Property Market: Australia’s property market has historically delivered strong returns, making it an attractive investment option. However, it’s important to weigh the costs of property investment, including loan interest, against potential gains.
Finding the Right Balance
For many Australians, the best approach is a combination of paying off debt and investing. Here’s how to strike the right balance:
- Pay Off High-Interest Debt First: Focus on eliminating high-interest debt, such as credit cards, before investing. This provides guaranteed savings and improves your financial stability.
- Build an Emergency Fund: Ensure you have a safety net in place before committing to investments. This prevents you from relying on debt in emergencies.
- Invest Regularly: Once high-interest debt is under control, start investing regularly. Consider options like salary sacrificing into super or setting up a regular investment plan.
- Review Your Strategy: Your financial situation and goals will evolve over time. Regularly review your debt and investment strategy to ensure it remains aligned with your priorities.
Seek Professional Advice
Deciding whether to pay off debt or invest can be complex, especially when considering factors like tax implications, interest rates, and investment returns. A financial adviser can help you create a personalised strategy that balances debt reduction with wealth creation.
Final Thoughts
Managing debt wisely is about more than just paying it off—it’s about making strategic decisions that support your long-term financial goals. By understanding the trade-offs between debt repayment and investing, you can create a plan that maximises your financial potential.
Remember, there’s no one-size-fits-all answer. The right choice depends on your unique circumstances, goals, and risk tolerance. Take the time to evaluate your options, and don’t hesitate to seek professional advice to guide your decision-making.
If you’d like to explore your options for managing debt and building wealth, click here to schedule a complimentary consultation with an EPG Wealth adviser.