People often ask me is it better to pay off debt or invest money for the future.
This is a great question. If you have a little a cash left over every month, then what should you do with the money? Should you use it to pay off your debt more quickly by making extra payments? Or should you earmark that spare cash for saving and investing?
The answer really depends on a few things:
- How much you have saved up already
- What kind of debt you have
- What your wealth building goals are
Investing vs Paying Off Debt: Finding the Middle Ground
If you’re juggling several high-interest credit card balances, combined with student loans, auto loans, as well as a mortgage, then you may feel at times like there’s a huge boulder sitting on your shoulders. Getting rid of that burden, or at least reducing it, will help keep you calmer in the face of unexpected expenses. It will give you more financial freedom and flexibility, and ultimately help you live the lifestyle you want. A. lot. sooner.
But at the same time, saving for the future is important, too. And the earlier you get started the better.
So if you have a little money to spare at the end of the month, what should you do? Should you use it to pursue your debt until it’s gone, and leave the investing for later? Or, should you just take care of your monthly payments now and invest those excess funds in future needs, such as retirement?
Often, the solution involves some combination of the two. In this article, we’ll go over six factors you should consider in order to decide whether to invest or pay off debt.
Is it Better to Pay Off Debt or Invest?
Is it better to pay off debt or invest? Now that we have you thinking, ask yourself these six questions for better clarity.
#1 Do you have an emergency fund?
If you haven’t set aside money in a dedicated savings account to pay for unexpected expenses, then this is where you should start – regardless of how much debt you have or even if you’ve been putting off investing for years. I call this a financial freedom account because you’ll be able to use it in a pinch without having to rely on your credit card (meaning added security). And you’ll be able to make a spontaneous purchase here and there (meaning added flexibility).
At a minimum, you should aim for three months of living expenses. To reach that amount, you can set up a small weekly or monthly automatic transfer to the account. One of the side benefits of having a financial freedom account is that it builds healthy money saving habits.
#2 Are you currently paying into a retirement plan?
In the US, if you or your spouse has access to a 401(k) and your employer is making matching contributions, then you should make it a priority to max out that employer match. This is the best return for your money since you not only “earn” the money your employer puts in, you also reduce your tax obligation. And, these are guaranteed returns.
In the 2018 tax year, you can invest up to $18,500 in a 401(k) with pre-tax dollars if you’re under the age of 50. If you are 50 or older, you can contribute an additional $6,000. Contribution to a traditional IRA also comes with tax benefits.
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#3 Have you tried to reduce the interest rates on your existing debt?
If you have good credit, then before funneling any additional money to pay off your debt sooner, try to make your high-interest debt less expensive. There are several ways you can reduce the amount of interest you are paying on a loan or a revolving line of credit. Some lenders, like credit card companies, may be willing to reduce your interest rate if you ask them to, especially if you’ve built up a good history with them.
Alternatively, you can use your good credit to your advantage by looking for a credit card with a low-interest rate or zero percent promotional financing offer. You could then do a credit card balance transfer. You will typically have around 12 to 18 months to knock out as much debt as you can before the promotional rate expires.
Finally, if you have a lot of high-interest debt, from credit cards or short-term loans, then a debt consolidation loan may make sense for you. Be aware of any early payment penalties on the loans you are trying to get rid off to see if it is still worth it. And even more importantly, make sure you have a solid financial plan in place to pay off your loan so that you don’t end up going back to your credit cards and digging yourself into an even bigger financial hole.
Which leads us to the next important question…
#4 What kind of debt do you have?
Not all debt is created equal. Some kinds of debt are better than others, and for that reason, you need to create a debt hierarchy. List all of the debts you are paying off starting with:
- high-interest credit cards or short-term loans (over 10% interest),
- mid-range financing (6%-10%), and finally,
- low-interest products (less than 6%)
When deciding whether to pay off debt or invest your money, the general rule is if you can earn a higher return on your investments than the interest on your debt, you should invest. Assume that a reasonable, well-balanced portfolio could bring you an average net return of 6%. This means that paying off any debt carrying an interest rate higher than 6% would offer a better return for your money.
If you have any high-interest debt, then it just makes financial sense to pay it off as quickly as you can.
On the other hand, paying off any low-interest, long-term debt, such as a student loan or a mortgage, may not make sense since the financing doesn’t cost you so much. It may be as low as 2 or 3%. In the US you may even be able to get tax breaks on your mortgage interest to help make the payments more manageable. In this case, you could get a much better return on your money by investing.
Use this free debt payoff worksheet to compile a list of your debts and to rank them by interest rate and remaining debt outstanding.
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#5 What are your current financial goals?
Aside from the considerations we mentioned above, there are several factors that could affect how you allocate your money, such as:
- Your age
- The number of dependents you have
- The nature and level of your income
- Your health
- The value of the assets you own
If you are young and healthy with few dependents, and you are already paying into a retirement account, then some of your excess money could be used to pay off not just high-interest, but even low-interest debt (4% to 6%). Being completely or nearly debt-free will give you a tremendous amount of financial freedom that can help build your wealth without being hindered by the financial obligations that seem to follow some people around for decades.
If you’re older, however, and you have not yet saved enough money for retirement, then a greater proportion of your money should be directed to your retirement planning. Read this post to see how many Americans have nothing at all saved for retirement.
#6 Has anything changed in your financial situation?
Working your way through the previous five questions will help you to decide whether to pay off debt or invest in your future needs. But every few years as your financial situation evolves and changes, you need to revisit and reconsider these questions anew. For example, as you pay off your debt, you may have even more money to work with at the end of each month. In that case, more money could then be directed to your investments and other wealth building activities.
In closing… Keeping yourself focused and motivated to tackle your debt, save, and build your wealth, is extremely important. And, one of the best ways to do that is to ask yourself these six questions, to make informed decisions, and to make a conscious choice to build healthy money habits.
What do you do with spare cash at the end of every month? Let me know in the comments below.