Pay Off Debt or Invest
Pay Off Debt or Invest – Which is Better?
Either one is an acceptable goal, but is one better than the other, or maybe you should do both? There are many opinions to the answer to this question, so let’s explore some of them. People who have created a budget and have extra cash, are sometimes faced with this dilemma.
So, should you pay off debt or invest that extra cash? A broad answer is there is no one size fits all situation. It all depends on a lot of factors surrounding your personal financial circumstances.
Using your spare cash to invest or pay down debt fast are both good uses of money. Investing might make more sense providing you are able to earn more from the investments than the amount of interest you are paying on your debt. On the other hand, repaying high interest debt will more than likely give you a better return than your investments.
Pay off debt or invest – Key Differences
Investing is how you put money aside for your future. Ideally, you would invest in bonds, mutual funds, or stocks that over time would grow in value. On the other hand, debt represents money already spent that you’re paying interest on to a lender. If no repayment is made, interest and penalties are added to the balance, and it compounds.
General rules for investing
The general consensus says that if investing extra cash gives you a better rate of return than what your debt costs you, then investing makes more sense. As an example, if you invest your extra cash in an index fund that has earnings of 10% per year and your mortgage has an interest rate of 5%, you’ll be better off investing in the index fund.
However, if your credit card debt is costing you 20% per year, then using the extra cash to repay the credit card makes more sense than investing in that 10% index fund.
However, it’s seldom that straightforward because of variable issues. Investing in stocks and similar instruments, can and usually is volatile. Index funds can be up over one year and down the next. There are investments paying a guaranteed rate of interest such as US Treasuries and bank CD’s. But these types of investments generally have low rates of return that very rarely tend to be higher than the interest rate you pay on credit cards.
Another factor that comes into play is your risk tolerance, which is psychological. Some individuals are comfortable taking risks with their investments. They know that investments don’t have an upward curve all the time. They usually fluctuate with the market that can be volatile.
There are others that have a very low risk tolerance and are kept awake at night with high concerns regarding the following day’s market. So, should we pay off debt or invest?
General rules for paying off debt
When we look at the general rules for paying off debt versus investing, sometimes the issue isn’t so clear. Having a lot of debt in high interest credit cards might make more sense to repay as quickly as possible. Studies show that the average interest rate for credit card debt is just past 19% per annum.
You would have to look long and hard to find a worthwhile investment paying a return that high, if you ever could. Using your extra cash to repay this debt makes perfect sense. But another reason to get rid of this type of debt surfaces.
That reason is an improvement in your FICO credit score. We all know that the higher our credit score is, the better it is to qualify for borrowing, and at a lower rate of interest. Further advantages of a high credit score include items that can have an effect on every aspect of your life. A few of these would be premiums you pay for insurance and whether you’d qualify for an apartment lease. And don’t forget job applications. It appears here that the question of to pay off debt or invest is more clearer.
The calculation of a credit score takes into account several factors. One of the most important is your credit utilization ratio. This is calculated by the amount of current debt you are using as compared to how much you have available. So, if you have your credit cards maxed out, you will have a lower credit score.
This additional important factor is another reason to pay off those credit cards, or at least, pay them down to an acceptable level. Many individuals aren’t aware of this factor, and consequently, tend to have a lower credit score than others who do. Paying them down or off is a very smart move.
Psychology enters into this too, just as much as in investing. If having a lot of debt is causing you to have anxiety and maybe losing sleep that can affect your health, then pay off those debts even if it means you could get a much better return by investing your extra cash.
General rule for doing both – payoff debt or invest
Paying down your debt versus investing, does not have to be an either/or decision. There are times when you should be doing both at the same time. As an example, if you don’t have an emergency fund, use some of the extra cash to start one and use the balance of your extra money to pay against your debts. The question of pay off debt or invest might be a harder decision for some.
We don’t recommend investing the emergency fund in a bank CD, or in stocks either. This fund should be able to convert quickly into cash when it is needed, so it needs to be liquid. Probably a good money market mutual fund would be a good choice.
How to Pay off debt
Once you’ve made the decision to pay off debt fast with your extra cash, you need to decide on your approach. The answer is very simple if you accumulate enough cash to cover all of your debt, just pay everything off and relax.
However, most of us don’t have that much extra money, so you will have to prioritize. A general rule is, you’ll get out of debt quicker if you start paying off the one that has the highest rate of interest first.
When it comes to credit cards, you have a couple of options. The first is to get a balance transfer credit card, where all of your credit card debt is moved to. Many of these types of cards will offer you a promotional period whereby no interest is charged for periods of 6 months and up to 18 months. This will enable you to pay off that debt fast because all payments go towards the principal.
Another option is to apply for a debt consolidation loan from a bank or other reputable lender. This will allow you to have only one loan, and probably at a lower rate of interest than your credit cards were. Now, all spare cash will be applied to that loan. The question of pay off debt or invest, is very apparent.
What if you’re really deep in debt
Usually when an individual is very deep in debt, their extra cash is non-existent, and more drastic measures may be required. Being in that condition, chances are that you’re struggling to even make the minimum monthly payments on your debt. Contact your lenders before you start missing payments.
They will usually offer to reduce the rate of interest or lower your monthly payment, sometimes both. Keep them in the loop by all means and advise them of your financial problems before it gets too bad. Borrowers who maintain good communication with a lender, will get the most help generally
Another option is talk with a reputable debt relief company, and let them negotiate with your lenders. Be very careful in this area because it’s full of scams, some who are nothing more than unscrupulous predatory loan sharks. THE Federal Trade Commission has been trying for years to catch some of these people, and does.
The shady operators will almost always charge you a fee up front, and the actual service they provide, is questionable at best. Investopedia publishes the annual ratings of the best debt relief companies. (Investopedia is one of the best-known sources of financial information on the internet. The website serves as a resource for investors, consumers, financial professionals, and students who seek guidance or information on various topics.)
Being in a situation where you have extra money, is very enviable. Having to decide whether it’s better to pay off debt or invest depends on many factors that only you can decide. Which ever one or both that you decide to do, is a lot better than just spending that money. Either way will allow you to be in a better financial condition than you were previously.
Gust Lenglet is the CEO of HBS Financial Group, Ltd., an accounting & tax preparation firm in Maryland. He has more than 25 years of experience in the banking and financial industry. Gust started his career as a loan officer at a major national bank, and then moved on to become controller of a major law firm. In recent years, he has written many financial articles that have been published on Ezine Articles and many websites.