So should you pay off debt, save or invest to build wealth and achieve your financial goals? Or can you do all three? Here’s how to think about where to put your money to achieve your goals and build long-term wealth.

It’s one of the most common questions that our financial coaches get asked: is it better to build some savings, start investing, or pay off debt? 

Investing can be a great way to build wealth over the long term, but many of us are in debt or don’t have a great deal of savings. The reality is that each option can help you to take control of your money – but which option should take priority?

The answer, of course, is that “it depends” and it’s up to you to make the decision that feels right for you, when you think about your objectives and needs. You may also wish to pursue multiple strategies at once. However, there are some important ways of looking at the question to help guide you to an answer. 

Let’s start by looking at debt (if you’re completely debt free feel free to skip)

Chances are, you’re likely paying off some form of debt – average Australian household debt grew by 7.3 per cent to $261,492 in 2021-22. This could come in the form of a HECS debt, a mortgage, or (the killer) credit cards.

But not all debt is equal. Debt can often be thought of as ‘good debt’ and ‘bad debt’ – good debt is when you borrow money for the purpose of buying an asset that will increase in value or bring in further income (like a home loan). Bad debt on the other hand is likely to have arisen due to spending that will not further your financial position (think credit cards/afterpay).

Thinking through whether to save, invest or pay back debt requires you to consider how much debt you have relative to your income and owned assets, as well as the interest rates on your debt.

Why think about interest rates?

Understanding the interest rate you’re paying on different types of debt is really important and as a general rule of thumb it’s beneficial to pay back debt that has high interest rates first. Why? Well check out this example.

Imagine you start the year with $1,000 debt across five different types of loans, all with different interest rates but all compounding monthly. Here is how that debt could look like after three years if you don’t pay back any of the debt or take on new debt.

Type of debt	Year One	Year Two	Year three
A home loan on a fixed 4%	$1,041	$1,083	$1,127
HECS debt on 1.9% p.a.	$1,019	$1,039	$1,059
Credit card debt on 16%	$1,172	$1,374	$1,611
A car loan on 10%	$1,105	$1,220	$1,348

(We calculated the above using the Australian Government Money Smart Compound Interest Calculator. You can use it to calculate your own debt.)

Now remember, it doesn’t actually matter how big the total amount of debt is across all the different loans. If you have $1,000 per year to put towards paying back debt, you’ll save more on interest if you pay back the loans with the higher interest rates first. 

So should you be trying to pay back all of these loans before you start saving or investing?

I’m so very glad you asked.

The answer is largely about interest rates.

At the time of writing there are opportunities to earn 4%+ interest in high income savings accounts. Meanwhile, the Australian sharemarket has had a long-term positive return of more than double this amount (an annual average of 9% over the past 30 years), although some years it’s more and some years it’s less and some years it’s negative, but that has been the trend historically.

Therefore, for most people, it makes sense to pay back high interest debt, but instead of paying back lower interest debt, it can make more sense to have cash in a high interest savings account or invested. 

For example, if you are still on a low fixed mortgage with an interest rate of below 2%, it may make sense to keep your additional savings in a high interest savings account paying over 4%, as you will be earning more on interest than you would be saving if you paid back some of your mortgage sooner. 

Similarly, many people decide to start investing to build wealth over the long term despite having a HECS debt or a home loan because based on historical share market trends, over the long term, there is a likelihood of earning more from the investment than you would save paying some or all of the loans back early. There may also be tax advantages of not paying back investment property loans sooner. 

When it comes to high interest personal loans “bad debt”, in most cases there is really only one sensible answer, and that is to prioritise paying these loans back ASAP and to do this before you start investing significant amounts of money. And generally you will be wanting to pay back the ones with the highest interest rate first to save the most on interest (regardless of the size of the loans).   

We have met members in our community who have decided to invest small amounts while still having personal debt in order to gain investment experience or build a sense of financial mastery. Similarly, many financial coaches will suggest that if you can wipe off a small loan – even if it’s not the one with the highest interest – that this can also boost your confidence. 

So, ultimately it is a personal decision. What’s important is that you have a plan, and clear debt goals that you can track progress against. 

Saving vs Investing

So you’ve finished paying back any immediate debt that you wanted to clear and now you’re accumulating savings. How do you decide whether to keep your cash in your everyday bank account, move it to a high interest account, or invest it?

The difference between saving and investing is whether you hold your unspent funds in cash or in some other form. Saving means setting aside cash for future use. Investing means using cash to buy other assets that you expect to produce profits or income.

How saving and investing differ

Saving is a cash activity. You hold back from spending cash and instead keep it in a savings account  or somewhere in your home. The goal is to have those funds available for later use.

When you invest money, you use your cash to buy another asset. The goal here is to earn profits or income. Examples of investing include:

• Buying stocks you expect to appreciate. When the value of the stock rises, you can sell it at a profit.
• Buying stocks that pay dividends. You can use them to pay bills or to buy more stocks.
• Buying real estate that earns rental income. The rents you collect should create profits after you pay your property expenses.
• Buying bond mutual fund shares or other fixed income shares that pay interest. As with dividend payments, you can use the income to pay bills or to buy more mutual fund shares. If you buy more shares, you benefit from compound interest. This is when your interest starts earning interest — a powerful way to build wealth over time.

When you should save

You should be thinking about saving when you have income but little or no cash on hand. Before you begin thinking about investing you should set a goal to build a cash savings balance that can cover six months of your living expenses. This protects you against unexpected financial emergencies such as a car accident or losing your job.

Saving is also appropriate for short-term financial goals. Examples include buying a home, paying for college, or funding a wedding. If your timeline for reaching the goal is five years or less, saving may be a better strategy than investing.

When you should invest

Many people feel nervous about the risk associated with investing. But there’s one graph that clearly shows why this is an attractive option for building wealth over the long term. See the growth trends below – yes the share market is volatile, but historically speaking, despite world wars, pandemics, and major financial crashes – it has over the long term gone in one clear direction: up!

You should therefore consider investing to build wealth when you have income, a cash emergency fund, and no high-interest debt.

Cash emergency fund. This cash helps you manage the risks of investing. Any asset you buy (whether it’s property, shares or something else) can lose value or fail to produce the income you expected. Stocks, for example, rise and fall in value daily. It’s easier to tolerate normal ups and downs if you have another source of cash available to cover financial emergencies.

Without cash on hand, you may have to sell your investments quickly if something bad happens. Selling too soon limits your profit and/or income potential. Worse, if you sell when your asset’s value is temporarily down, you may lose money.

There are some low risk investments that are appropriate for investing an emergency fund. These investments must be held in a place where you can withdraw funds within a short time frame (less than five days) and also should be low risk – typically these will be fixed income investments. 

No high-interest debt. Paying off debt provides a guaranteed return because you’re spared future interest expenses. Investing is less certain in terms of return potential and timeline. Take the sure thing and repay your high-interest credit accounts before you start investing money.

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