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You have some credit card debt, or maybe a mortgage, or you’re still paying off student loans. But, you also have some extra money to throw down. So should you be paying off debt or investing?
If the debt carries a high interest rate, (6% or more), then paying this first will be more beneficial. This is because any gains you receive from investing will most likely not be higher than 6% a year, meaning, your debt will still grow faster than your wealth.
While investing is an important tool to create more wealth for yourself, but there are a few considerations you need to make if you are still in debt, like the type of debt you have, the interest rates on your loans, as well as your risk level.
We’ll tackle each one of them in the article so you can get a better understanding, and ultimately make the best decision whether to pay debt first or invest.
Should You Be Paying Off Debt Or Investing?
Unfortunately, 77% of American households have some type of debt. Chances are, you fall in that category yourself.
But does having debt mean you should refrain from investing? Well, that depends on several factors that we’re going to cover below.
Remember, when deciding if you should be paying off debt or investing it’s important to take off the rose-tinted glasses and look at your financial situation realistically.
The last thing you want to do is end up with more debt.
Consider The Interest Rate
The first and most important thing to consider when debating paying off debt or investing is the interest rate on the debt you have.
Credit cards typically have the highest interest rates as opposed to the low rates typical on mortgages and other types of debt.
If your average APR on your credit card or other debt is higher than the average return of your investment, then it is best to pay off that debt before you start to investigate investments.
For example, the average credit card APR is 20.25 percent.
If you are investing in the stock market, you may face an average return of 10 percent.
Because it does not outweigh what you will be accumulating in interest on your credit card, you will want to pay off that card before you redirect your funds to investments.
On the other hand, you may have debts with low rates such as federal student loans.
If the interest rates are low enough, you may actually earn more by investing your money wisely as opposed to spending every spare cent paying down debt.
In other words, if you find an investment that grows at a higher percentage than your debt, it would be useful to continue making your regular debt payments, while investing in high-return opportunities.
An interesting way to think about this is in terms of compound interest. Compound interest works by re-investing your gains over a long period of time, and the earlier you begin investing the greater your return.
Distinguish Good Debt VS Bad Debt
I first heard these terms when reading a book by Robert Kiosaki, “Rich Dad Poor Dad”.
Good debt is practically a loan to make purchases that will pay for themselves.
Essentially, the investment you are buying will pay for itself in that over a period of time, it will pay off the borrowed money, and then continue making money to pay you.
For example, a mortgage on an investment property is good debt. The collected rent pays the mortgage payment as well as other associated costs of the property, eventually paying off the mortgage and then paying you.
Contrastingly, bad debt is debt that you take on that doesn’t pay itself down. This is borrowing money to purchase something, gaining ownership of that ‘thing’, and then making payments towards that purchase oftentimes with interest.
This grows into a worse situation when selling the item returns less than its purchase price.
The stereotypical example of bad debt is purchasing a vehicle, especially a new one.
You take out a loan from a bank or the dealer themselves, drive off the car lot, and already your new car is worth less than what you just paid for it.
Now, not only will you pay more for the car than its sale price, over the course of the loan, but if you decide to sell the car, you’ll see that its value has depreciated annually.
Consider Your Credit Utilization
Most lenders refer to your FICO credit score when deciding whether to issue you a new loan or credit card.
This score consists of five main areas:
- Payment history
- Credit utilization
- Length of credit history
- New credit lines
- Credit mixture
For our purposes, the important factor here is your credit utilization.
Credit utilization refers to how much of your available credit you are currently using.
Let’s say that you have a credit card with an available balance of $5,000. You carry a balance of $2,500 on the card.
This gives you a 50 percent credit utilization rate because you are using half of the credit available to you.
Why does this matter?
Your credit score is likely to be lower when your credit utilization is higher. Most lenders prefer to see a credit utilization rate that hovers right around 30 percent.
Anything higher can send up red flags that you are unable to afford your lifestyle because you are spending enough to max out your credit cards without paying the balance each month.
If you have a high credit utilization rate, you may want to consider paying down some of your debt prior to investing.
This can boost your credit score and make you more likely to qualify for other loans with better terms in the future.
Take Retirement Into Account
If you are close to retirement, you should consider aggressively paying down debt.
Carrying your debt into retirement can spell trouble for your financial health when you are typically on a reduced or fixed income.
Most experts recommend paying down high-interest debt before making huge investment decisions. However, the exception to this is investing for retirement.
Consider contributing even a small amount to your retirement fund each month. It will earn interest and compound year after year, yielding large dividends for you later in life.
Consider how close you are to retirement and how close you are to your goal.
For those who are close to retirement age and far from their goal, you may have to consider investing a bit more aggressively.
You may need to work a few years longer to make everything possible.
Those over the age of fifty are able to make catch-up contributions. Alternatively, you could do your best to minimize your expenses to slash the amount you need in your retirement savings account.
Figure Out Your Budget
How much room do you have in your budget for paying down debt or investing?
If you don’t have a budget at all, this is the best time to start one. You need to know how much money you bring in each month and how it gets spent before you decide to pay debt first or invest.
This can help you see where to cut unnecessary expenses, see just how much you have to spend each month to cover your debt payments, and know how much money you have leftover at the end of the month.
Many people, myself included, have a hard time crafting their budget.
Before I made a budget, I had no idea where all my money went at the end of the month, but I knew it wasn’t staying in my bank account. If this describes you too, here is what I finally did to make a budget.
I went through previous statements from my bank account and categorized each line item.
Then, I just simply added them all up and was then able to get a pretty accurate picture of my finances.
This will allow you to track all of your expenses so that you know how much you need to save, spend, or invest each month.
Pay Off Debt First Or Invest – Making The Right Choice
As a general rule, it is typically best to approach the issue of paying off debt or investing with a balanced mindset.
It can be beneficial to work toward both goals simultaneously, but there are some important things to consider when it comes to paying off your debt.
In certain circumstances (like high credit card debt), it may be better to pay down some of your debt with that spare cash before jumping into a new investment strategy.