You’re finally making good money. Now what?

After barely getting by for years, many millennials who are now firmly established in their careers suddenly might find themselves with excess money in their pockets. Here’s how to decide when it might make more sense to pay down debt or invest more for retirement.

If you’re in your mid-30s or early 40s, does the following example resonate with your financial situation?

You spent years working your way up the corporate ladder, perhaps enduring long nights as an associate in your firm, or completing your residency or fellowship. Now your career is finally taking off. New financial rewards are coming your way from a new job or promotion, hefty bonuses and other compensation that often didn’t seem possible to you in the early days.

For the first time, there’s a flood of financial opportunities, and you actually have the resources to consider them. You can buy your first house or move into a larger one. Maybe you’re now in a position to take a European vacation or buy a new car.

You may also be faced with the decision of whether it’s best to aggressively pay down your debt or save more money for retirement. Which strategy is the right choice for your circumstances?

Truth be told, many people are naturally debt averse. Likely, nobody enjoys the stress of having a large credit card balance or facing the seemingly endless payments to cover student loans. However, as part of a long-term financial plan, it’s not always optimal to allow our natural aversion to debt to control our decisions.

Determining the best option is largely based on a few important factors. How do you decide? Here’s a process to consider:

Be sure your financial foundation is sound

First, understand what I like to call the “financial order of operations.” Think of this concept as a financial version of Maslow’s Hierarchy of Needs, which depicts people’s basic needs as a five-level pyramid with physical needs on the bottom (i.e., most basic) and self-actualization on the top.

Before deciding whether to pay down debt or invest—items that are near the top of your financial pyramid— consider making sure your foundation is in order. Start by answering the following three questions:

1. Do you have an emergency fund in place? Having enough money to cover three to six months of expenses is typically recommended so you may not need to borrow if the car breaks down or another emergency arises.
2. Are you paying the required balance on your debt obligations each month to help reduce the outstanding principal while also avoiding penalties? If not, you likely need to consider beginning those.
3. Are you taking advantage of your employer match in your company retirement plan? Maximizing your company’s contribution may earn you a substantial amount of additional retirement savings over time.

If you haven’t checked all the items above, using excess funds to accelerate debt paydown or further invest in your retirement may need to take a backseat for now. In my opinion, you can’t construct a strong building on a weak foundation. 

Pay down debt with high interest rates first

While the term “high” is purely subjective, generally, a good rule to follow is to prioritize paying down debts with interest rates above 6% to 8%. For example, a credit card with a 16% annual interest rate should be prioritized over maximizing your 401(k) contributions. However, debts with interest rates below the threshold above require a little comparative analysis to determine the optimal financial strategy. Your wealth advisor can help you crunch the numbers.

Should you pay down more debt or invest?

Compare the benefits of paying down debt versus investing excess cash. 

For example, if you have $5,000 of additional income available, does it make sense to pay down student loan debt with a 9% annual interest rate or invest in a portfolio with an expected return of 6%? By investing all of the money and not paying down any debt, you would effectively have lost 3%, or $150, in a year’s time. In this case, paying down the debt is likely a logical choice.

However, if there’s a car loan with a 3% interest rate, the script is flipped—in a year’s time, you would gain $150 from investing your excess income.

On the surface, this break-even equation seems to provide the final solution to our question. However, using this logic in our decision-making may not always create the most optimal strategy. One shortfall of the equation above is that it’s nearly impossible to predict investment performance. So, would it be prudent to base our financial decisions solely on mathematical equations that derive their solutions based on unpredictable assumptions? In simpler terms, shouldn’t we avoid making decisions based solely on unforeseeable outcomes?

Take other non-financial factors into account

In my view, most people don’t like taking unnecessary risks. You may be wondering: “Shouldn’t I always make the best financial decision regardless of my attitude toward risk since it will usually result in the best outcome?”

The answer: It depends. In my opinion, the best financial plan is one that you can stick with because it’s designed for your specific needs and circumstances. If having student debt or a car loan keeps you from sleeping at night, it may be a better decision to pay down those financial obligations rather than invest the excess money.

Or, if you want to retire early—perhaps at age 50—and need to save as much as possible, it may make more sense to allocate a larger proportion of your excess money toward saving and less toward debt repayment. This approach would likely align more with your life goals. We all have our own preferences, attitudes, risk tolerance and objectives. Accordingly, what matters most to you may be the right answer.

When determining whether to invest excess income or use it to accelerate debt paydown, consider talking to your wealth advisor to devise a game plan that incorporates both the financial and non-financial factors that such an important decision entails. This will help you achieve your goals while further enabling you to focus on what matters most to you.

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