Should I Pay Off Debt or Invest My Money?
For those who have some extra cash, you might be wondering what you should do with it. You might have the cash from saving over time, or possibly a windfall like a tax refund. So what should you do with it? You probably know that leaving it in a standard checking account is not the right answer. But what about a savings account, or the stock market, and what about paying down my debts? There are many places you can consider to keep your cash, and in this post, we’ll explain which options might be the best for you.
Is Paying Off Debts Considered Investing?
You probably don’t think of paying off debt as an investment, but in some ways, you could consider it to be. Think of it this way: you have $1,000. You have a car loan that has a 4% APR. You could invest that money in the stock market. Or you could pay $1,000 towards your auto loan. If choosing the stock market, you will be paying $1,040 in opportunity costs on your auto loan. So you will end up paying $40 in interest costs. Assuming an average year in the stock market, you can assume a 7-8% return on your investments. If you were to put that $1,000 in the stock market, you would have $1,070 at the end of the year. With these conditions, investing your money in the stock market seems to be the wise choice, correct? But there is one big thing to consider, one of these options has risk, and the other has zero risk. That’s right, by putting your $1,000 towards the auto loan, you are essentially “guaranteeing” a 4% return on your money with no risk. By investing your money, you have some potential for risk.
The lesson here is that while paying off debts is not necessarily investing, you can think of it as a way to mitigate the risk of investing your money while ensuring a small “return”.
Investing Comes with Risk
Anytime you choose to invest your money, you have the potential to lose it. And with more risk comes more reward. The stock market comes with average risk and typically yields 7-8% annually. A savings account comes with extremely low risk, but typically only yields 1-2%. You must determine your risk tolerance based on your financial situation to guide your decision on what is right for you.
Are you prepared to lose your investment?
You should never invest money if you cannot afford to lose it. This should help to make your answer quite easy. You should choose to pay down your debts if you cannot afford to lose your investments.
Where Should I Invest my Money?
If you are new to investing and don’t have experience investing, it’s probably wise to pay down debts until you are capable of making smart investment decisions. Inherently, investing is not difficult to understand. Others will use your money to create value and then disperse that value back to you in the form of interest.
For example, a savings account could be considered a small investment. You deposit money into the account in which the bank will use to finance mortgages for homebuyers. In return, they will pay you a small amount of the profits generated in the form of interest payments at the end of each month.
NOTE: Banks use your money for more investments than mortgages. They could also finance personal loans, credit cards, or other products that generate income.
There are many different investments you can make with some being riskier than others. One of the best options for many is a low-cost mutual fund or ETF. In simple terms, these are groups of stocks or investments that when put together mitigate market volatility in order to maximize your risk-reward ratio.
Look at Your Finances
In order to decide what you should do with your money, you’ll need to understand your personal finances on every level. You should have a budget in place to understand your income and expenses. After all, it probably isn’t a wise decision to go investing your money if you do not have a positive cash flow at the end of the month.
Are you adding to your savings regularly?
If you’re adding money to your savings at the end of each month this is a good sign for your finances. On the flip side, if you’re cash strapped at the end of the month, your finances probably need some more work. This should help guide your decision making when trying to decide where to put your money.
Do you have an emergency fund established?
Emergencies will happen, it’s only a matter of time. Could you afford an unexpected emergency room visit or a car accident? If not, this is probably a good place to start with your finances. We recommend starting by saving $1,000 and then proceed to save 3-6 months of your living expenses. You can read more about saving for your emergency fund here!
For those with a rising income, you might lean towards investing some of your money knowing that you’ll still be able to pay off debts as your income rises. For example, those just out of college can expect to have an increased income over the next 2-5 years, making investing their money a smart decision given the right circumstances.
What are the Terms of Your Debts?
Do your debts have a 2% APR or 27% APR? This question is one of the most important to help you make the best decision for your money. If you have credit card (or any) debt that incurs well over 10 or 20% of interest annually, you should aim to pay down that debt as quickly as possible. If you were to invest that money, you’ll likely only yield a 7-8% return, making the opportunity cost very high.
It’s also wise to consider how your interest is calculated. Some debts will use simple interest, while others might be compounding (like credit cards). Compounding interest will effectively charge you your APR on the interest you incur. For example, credit card interest is often compounded daily. Therefore, any interest you incur on day one will be added to your total balance on day two.
As a guideline, it’s wise to pay off any debts with an interest rate at or larger than 8% (especially those in which interest is compounded) but you should always consider your own situation before making any decisions.
Best Debts to Pay Down Early
- High-Interest Credit Cards
- High-Interest Personal Loans
- High-Interest Student Loans
What about Compounding Returns?
It’s worth noting that when you invest money, your returns will also become part of your investment. For example, if you earned $50 in interest from a savings account in the first year of opening the account, the second year you will also gain interest on that $50. This is a very basic example of compounding interest which can make your decision more difficult.
If you have a debt that only incurs simple interest (I.e. it does not compound) like a personal or auto loan, it might be a wiser decision to invest your money to take advantage of compounding interest. On the other hand, if your debts also compound, paying them down is probably a better decision.
Deciding whether to pay off debts or invest extra cash can be a difficult decision. Ultimately, you’ll need to consider many aspects of your own financial situation as well as the opportunity costs for both repaying debts or investing your money to make a sound decision. Typically it’s wise to pay down high-interest compounding debts such as credit cards and some student loans first, and then investing any additional cash. For loans that incur simple interest, like auto loans, you should consider the impacts of compounding interest if you were to invest your money into your equation.
Whether you decide to pay down debts or invest your money, you are moving one step forward in your journey to financial freedom and should be commended for doing so. So pat yourself on the back and know that either way, you’re doing the right thing!
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