When it's okay to wait to pay off debt

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Rather than living paycheck to paycheck—a situation that describes more than one in three American workers across many different income levels—imagine having $200 left over after covering your monthly expenses, such as groceries, health care, and your rent or house payment. There are generally two paths people consider with that extra money: paying off their debt or investing in the stock market to watch their money grow and save for retirement. So which option sets you up for a better financial outcome in the long run?

There is no simple answer, but there is a useful rule of thumb to help guide your decision. Experts often point to a tipping point of a 7% interest rate—the rate at which a debt or investment grows over time. You might sometimes see this tipping point as 6% or even 5%, depending on factors such as how close a person is to retirement. However, for the purposes of this discussion, 7% is used because it represents the lower end of the growth you can expect from long-term investing.

If your debt carries an interest rate below 7%, it is mathematically more beneficial to invest that extra $200 in an index fund—an investment fund that tracks the performance of a market index, such as the S&P 500. Index funds offer a hands-off way to invest with generally lower risk compared to investing in individual stocks. Historically, the S&P 500 has grown at an average rate of about 7% when adjusted for inflation, though some years may be much higher and others lower. Generally, if your debt’s interest rate is below 7%, investing tends to earn more over time than focusing on paying off the debt immediately. Conversely, if your debt rate is above 7%, the interest that adds to what you owe can outpace the potential growth from investing.

Consider a practical example: Suppose you have $10,000 in debt at a 5% interest rate—a figure close to the average rate for federal student loans over the past ten years. Assume this debt requires a minimum monthly payment of $150 along with your other expenses. Various online calculators can show you how long it will take to pay off this debt and how much total interest you will pay. In this scenario, if you only make the minimum payment without contributing any extra funds, it will take about six and a half years to pay off the debt, and you will accrue roughly $1,700 in interest on top of the original amount.

Now, if you add an extra $200 per month toward this debt, you could pay it off in about two and a half years, with total interest of under $700. In other words, paying off the debt faster would save you roughly $1,000 in interest. On the other hand, if you choose to pay only the minimum on your debt and invest the extra $200 each month in the S&P 500 at a conservative 7% return, you could earn around $4,000 in interest over the same period. Although you would add $1,700 in interest to your debt, the investment earnings would put an extra $2,400 in your pocket compared to paying off the debt sooner.

Let’s consider a different scenario with a higher debt interest rate of 13%—a typical rate for a subprime auto loan for someone with a below-average credit score. With the minimum payment strategy, it would take almost ten years to pay off the debt, and you would accrue approximately $7,800 in interest. By applying an extra $200 per month, the debt could be eliminated in just under three years with roughly $2,000 in interest, saving you about $5,800. If instead you chose to invest that $200 each month over the ten years, you might conservatively earn around $10,000 in compound interest. However, after subtracting the $7,800 in interest accrued on the debt, you would net a gain of only about $2,400—less than half of what you would have saved by paying off the debt sooner.

Ultimately, whichever option—debt repayment or investing—results in a higher effective rate of return should generally be the preferred choice. It is important to note, however, that using the 7% rule of thumb is just one guideline, and life’s financial decisions are more complex than a single mathematical equation. Different types of debt carry different costs, and individual circumstances vary.

Before deciding how to allocate any extra cash, a financial planner might also advise setting aside an emergency fund. A common recommendation is to have at least $1,000 saved to cover unexpected expenses, although ideally, this safety net should be larger.

Investing in the stock market always comes with some risk, which is an important consideration when deciding between the “7% rule” and other financial priorities. For those who prefer to avoid the risks associated with investing, the decision might be clearer, regardless of the interest rate on your debt.