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Should You Pay Off Debt or Invest Your Money? Here’s What You Should Think About
Let’s say you come into a small windfall of money or find yourself with a higher income. If you have extra money coming in, what should you do with it? While paying off debt is always a smart move, maybe it’s more worth it to invest your money for retirement.
So which should you do: pay off debt or invest your money?
Consider what one reader, Andrew, wrote in:
My girlfriend and I bought a home last year and qualify for the First Time Homebuyer Credit. When you include my share of this, I will be getting back around $4,500 in my tax refund. This is a lot of money to me and I’m trying to decide what to do with it. About half will go toward an engagement ring, but I’m torn between investing the other half or paying off my $2,000 in credit card debt. I currently have a very low APR on the credit card and can pay more than the minimum each month. As a licensed broker, I am very involved with the markets and believe I can make 10%–15% a year. If I can get a higher percentage return on the investments than the APR I pay on the card, doesn’t it make more sense to invest?
Andrew’s dilemma is something that almost everyone who has simultaneously wanted to pay off debt and invest eventually faces. Should they be directing extra money toward investments or toward paying off debt?
[ Next: 11 Ways to Get Out of Debt Faster ]
There’s an easy answer to this question, but the better answer involves a deeper look at your personal financial situation.
Compare interest rates
The simple answer is to look at the interest rates. Start by assuming that your investment will have a long-term return of 7%, an amount suggested by Warren Buffett as a likely long-term return rate for the stock market.
If the interest rate on the debt you’re trying to pay off is higher than 7%, you’re going to be money ahead by paying that debt off first before investing. On the other hand, if the interest rate on that debt is below 7%, you’re better off investing and just making minimum payments on the debt.
That’s the simple answer. It’s the answer that will give you the best pure return on your dollars assuming your life is in a perfect bubble. Since no one’s life is in a perfect bubble, however, it’s often not the best answer. Let’s look for a better solution.
Consider your financial situation
Here are five key questions you should ask yourself before deciding whether to pay off debt or invest for the future.
[ More: Here’s the Average Debt in Every State ]
Do you have cash emergency savings?
The first thing you should consider is whether you have access to a significant amount of cash to be used in an emergency. This should not be a credit card, as credit cards can be canceled by banks or rendered useless in many emergencies. You should have an emergency fund of $1,000 if you have high-interest debts, and at least a month’s worth of savings if you don’t have high-interest debts to pay off. Furthermore, setting up an automated emergency fund is recommended.
If you don’t have cash savings for an emergency, you are very likely to accumulate additional high-interest debt as soon as an unexpected event occurs in your life, undoing any progress you made with paying off debt or investing. Accumulate a small pool of cash for emergencies before you do anything else.
Are your debts at a low interest rate?
In general, an interest rate below 7% is considered a low interest rate, as a 7% return is what you can easily get with a broad stock market investment. You should put addressing your high-interest debts at a very high priority once you have an emergency fund in place.
However, that doesn’t mean simply throwing money at your debts. You should make it your goal to reduce the interest rates on your debts as much as possible. Have you consolidated your student loans? Have you lowered the interest rates on your credit cards, or moved them via low interest balance transfer offers? Have you refinanced your mortgage to lock in a lower rate? Those moves may be able to reduce the interest rates to a low level on most of your debts.
Are you on a reasonable retirement savings pace?
Examine your retirement savings progress. You may want to use a retirement savings calculator to get started, but a good rule is that if you’re under 30, you should be saving 10% of your income for retirement, and if you’re over 30 and didn’t save much before you were 30, you should be saving 15% of your income for retirement.
If you’re below that pace and have an emergency fund and your debts are mostly low interest (or close to it), you should prioritize getting your retirement savings up to that level. If your employer offers matching funds in your retirement plan, that’s even better, as it means you can contribute less than 10% or 15% but still be putting that much away for retirement!
Assess your five- and 10-year goals
Are you considering a career switch? Are you thinking about a cross-country move? Are you going back to school or launching a small business? Perhaps you’re considering having a child and are thinking about the possibility of stay-at-home parenting.
If those types of choices are in your future, you should again prioritize eliminating debt for cash flow reasons. Your shifts in lifestyle are likely to create situations where your income is lower, at least for a while, and having fewer bills to pay will make surviving those leaner moments much easier.
In short, paying off all debt and avoiding more of it is better if your future (in the next five to 10 years) seems likely to be unstable. The more stability you see, the better investment becomes.
Remember, there is no wrong answer
If you’re like most people, some ideas above will nudge you toward investing more, while other ideas will nudge you toward paying off debt — and that’s completely normal. What it means is that no matter what you choose, you’re not making a bad choice. You should choose the one that feels the most right to you given your situation. Both options will move you in a positive financial direction.
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