Do I pay off debt? Do I invest? Or, wait. Should I build that emergency savings first?

One of the great things about life is that we have choices. Lots and lot of choices. But those choices can also become a little overwhelming. Because with all of the choices in front of you comes a lot of opinions telling you loudly what you should and shouldn’t do. Especially with your money.

We’ve all heard some people proclaim that debt is the worst thing you could ever have. They preach getting rid of all debt, including your mortgage, so you can live a life unencumbered.

At the other end of the spectrum, there are the return chasers. The people who borrow money cheaply in hopes that they can make more with their investments than they can on the borrowed cash. To them, if you’re not doing this, you’re doing it all wrong.

What’s right? What’s wrong? And what’s the best approach for you?

When I graduated from business school with a lot of debt, I was facing the choice as to whether I should pay off that debt or invest more aggressively. Now that Jordan and I own a house and a piece of land, we face the same questions: do we pay off our mortgage and live a life without debt burden or do we invest?

When we looked for advice, we found everything. From the idea that having a mortgage (or even owning a home) will keep you chained to the man for your entire life, to the fact that Warren Buffett had a mortgage and thinks buying a home is a great idea.  

Honestly, could this contradictory advice get more confusing?

After research, spreadsheets, and a little soul searching, Jordan and I came up with this:

There’s the math, which will give you one answer. And there’s your personality, goals, and risk preference which will give you another.

What’s right for you, is somewhere in the middle. You have to find what works for you, for your personality type, for your situation, and for your sanity.

I’m not giving anyone personalized financial advice on what route is best for them – because that would be wrong – but I wanted to share the thought process Jordan and I have used when making this decision in our own life. After feeling indecisive about what we should tackle first,  we broke things down into 3 phases that made making a good decision a lot easier for us.

Phase 1: Stabilize

If you’re in this phase, you might feel like you’re in the midst of a financial free fall. Everything feels like an emergency and you don’t even know where to begin. There are 3 areas that most people agree should get your attention: high-interest debt, 401k match, and an emergency pillow.

High-Interest Debt (aka crippling debt)

You know what I’m talking about here. This is the debt that feels overwhelming and weighs heavy on your chest. You avoid looking at your credit card bill and you don’t even really know how much you’re paying in interest each month.

Maybe all debt feels crippling to you, but this debt really and truly can keep you from living a big life. Why? Because when interest rates are so high, there are very few ways for you to make a better return on your money.  When you have a credit card rate with an APR (annual percentage rate) of 20%, you’re paying $1,000 in interest each year on a $5,000 balance.

What’s included in high-interest debt? Credit card debt, personal loans, and anything where the debt is reaching into the double digits.

Making this debt repayment a priority is pretty much an undisputed truth: get this paid off, because you don’t have time to waste your days worried about debt. You’ve got some great things to go do.

Employer Retirement Match (aka “free” money)

Also included in this phase 1 is any retirement savings match that your employer offers. Let’s say your employer has a good employee match and for every $1 that you put into retirement, they’ll match it with 50 cents, up to a maximum of 10% of your salary. If over the course of the year, you put $6,000 of your pre-tax money into a 401k and they match it at that level, you’ll have $9,000 put away into retirement.

Not only have you taken advantage of the additional funds your employer will put toward your retirement, you’ve also set aside that money to grow tax-deferred: you didn’t pay tax on that $6,000 before it was invested and you’ll pay tax on it when you retire. Had you opted to not put that money toward your 401k, you would have paid tax on it immediately. If you are in a 25% tax bracket that would mean you would have had an extra $4,500 cash in your bank account rather than an extra $9,000 invested for your retirement.

An Emergency Pillow

We’ve all heard about how important it is to have an emergency savings account that equals 3-6 months worth of your expenses. But when you’re digging yourself out of high-interest debt, or your struggling to set aside money for your employer retirement match, building up a bank account that large feels overwhelming.

And it is.

Rather than focusing on building up that bank balance, I like to think of having a small emergency pillow instead. A “pillow” is $1,000 – $3,000 that you have stashed away in savings that you can reach for when the unexpected pops up, like a car issue or taking your dog to the vet in the middle of the night (been there).  

The idea is that you can reach for that pillow to help cushion these expenses without derailing your debt payoff or your employer match retirement savings.

Phase 2: A Strong Foundation

When you’ve taken care of the things in phase 1, the pressure comes off a bit, which is great. But then when you look at all of the choices in front of you, it’s easy to get thrown off.

The good news is that you don’t have to choose just one thing to focus on. It’s not an either-or situation. You don’t have to choose between continuing to save for retirement or paying off more debt. You can make small progress in each area, or you can choose to focus on one are to completely take care of it.

Tax-advantaged retirement accounts

Uncle Sam wants you to be able to retire. Eventually. While in Phase 1, stabilize, you put aside enough money to take advantage of your employer match, that likely won’t be enough for you to sail away into the sunset on during your golden years.

You do have an option to invest in other retirement accounts, outside of your employer through an IRA (Traditional or Roth). Before the age of 55, you’re able to put $5,500 per year into an IRA, as long as you don’t make more than the income cap.

Here’s why this is a good thing to start now, rather than put off: you have an annual limit as to how much you can put in an IRA. If you don’t invest money for 3 years, you don’t get to play catch up later. It’s a use it or lose it situation when it comes to the tax benefits. It’s a good idea to use it.

Debt with interest above 5% (but not the crippling debt from phase 1)

Here’s where things start to get a little gray for people. Is it wise to pay off your non credit card debt? These could be student loans, a home equity line of credit or something else that’s just nagging. Do you pay this off or keep investing?

Historically, the stock market has averaged a return of 7%, but in some years the returns have been much higher and in others, it has been much lower. If you pay off the debt you are getting a guaranteed rate of return in that you don’t have to pay interest. But you could be losing out on larger returns.

Financial advice is mixed on whether you should pay this off before investing more. At the end of the day, you have to do what’s right for you.

My student loan debt was in the middle of this gray zone, sitting right around a 5% interest rate after refinancing. I decided to pay it off, rather than invest further or build an emergency savings account, not because I thought it was the smartest move financially (the markets returned double digits over the time period I was paying off the loan). But I chose to pay it off because psychologically I needed to get rid of it so I could enjoy other things in my life.

Emergency fund savings

It’s time to take that little emergency pillow that you have saved from phase 1 and grow it into something more substantial. During this phase, the goal is to continue putting some cash away to eventually get up to the 3-6 months of expenses saved in an emergency account.


Phase 3: Grow

Once you get to this phase, opportunities for your cash really begin to open up – and get fun.

Other Investing Opportunities

Once you’ve maxed out your tax-advantaged retirement account options (IRA and 401K), you might eventually need to look at other investments that you can bring into your life. It’s likely that an IRA and a 401k won’t be enough savings to fund all of your life dreams, so having other investments can help round out your overall financial picture.

This can be as easy as opening up a brokerage account with Vanguard or a robo-advisor like Wealthfront and making monthly transfers into different funds. See this article for more information.

You may decide that you’re really excited about real estate and want to jump in on a rental property. Or maybe you have a child and you’re ready to open up a 529 college savings plan for them. The point is you have a lot of options to you now that you’re ready to grow, it’s time to see what makes the most sense for your next investments.

Other savings accounts

You likely have bigger goals in life, other than just working for 35+ years and then retiring. I know that I do. These other savings accounts are the perfect opportunity to get really specific about those goals and begin funding them.

Some of the savings accounts that we’ve set goals for in the past are:

  • Vacation savings
  • House savings
  • F-Fund (f-it fund or freedom fund)

You can read more about that last one, and why we love it so much, here.

Low-interest debt

If you really hate debt – including low-interest debt – this growth phase is likely the best time for you to knock it out. Before paying off any low-interest debt you’ll want to make sure that you’re taking advantage of any retirement investment opportunities to be sure you’re set up for the future.

In this growth phase, Jordan and I have found it extremely helpful to use Personal Capital’s free tool to get an overall picture of our money. It helps us know exactly where we stand (how much debt we have outstanding and what our assets are), plus we are able to use the retirement planning tool to help us project if we’re putting enough away for our beach walking, Mai-Tai sipping years

Phase 4:

Here’s a reality about your money: it’s going to ebb and flow throughout your life. You might have planted yourself firmly in the Grow phase only to lose your job. Or you decide to make a major life change or have a financial situation pop up that requires you to take on more debt.

Things aren’t always going to be linear and that’s ok. The most important thing to remember is that you have choices, and you can do what’s best for you at that time, given what phase you’re in.


Note: we use Personal Capital to track all our accounts in one place. It’s a free tool that makes organizing things easier. The links in here are affiliate links, but I only recommend it because I use and love it (and because it’s free!). You can read more information on our affiliate disclaimer here.

Photo by on Unsplash

Erica Gellerman Bio The Worth Project

Erica Gellerman is a CPA, MBA, personal finance writer, and founder of The Worth Project: personal finance and family travel. website. Her work has been featured on Forbes, Money, Business Insider, The Everygirl, The Everymom, and Lifehacker. When she's not writing about personal finance you can find Erica exploring Europe from her temporary home base in London.

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