Deciding whether to payoff debt or invest excess cash
Should we prioritize paying down debt or investing?
This is one of the most common questions I receive from people of all levels of income or wealth.As with many financial decisions, there is no one size fits all answer. The correct decision will vary from one situation to the next, as not all debts are created equal. But there are some general guidelines to assist in making the best decision.And remember, this does not have to be an either-or decision.You can, and likely should, do both at the same time. But you will need to find the proper balance and create an intentional strategy for both.
Factors that impact your decision
Interest rate and debt balance
It is important to first get a clear understanding of your debts. What is the balance of each debt, the interest rate and the current payment strategy?Are they “good” debts such as a mortgage, or are they “bad” debts such as credit card balances, personal loans, auto loans, etc.Do you currently have a payment strategy or are you paying different amounts here or thereoFor example, a mortgage has a fixed payment schedule that pays off the loan in its entirety over a predefined time frame.By knowing what your entire debt picture looks like, you can then get a better understanding of what the strategy on each debt will be.A mortgage with a low interest rate is likely to be treated differently than a large credit card balance with an extremely high interest rate.
Mortgage rates are extremely low and offer tax benefits while high interest rate consumer debt should be avoided at all cost, as they can get you into extreme financial trouble over the long run.If you have multiple high interest rate debts then look into the “snowball” and “avalanche” repayment strategies to start chipping away at the debt strategically.
Compare the cost of the debt to your potential investment return
Let’s dive deeper into an example of how credit card debt and a mortgage might be treated differently in the question of whether to invest or pay down debt.
Let us assume that you have credit card debt of $10,000 with an interest rate of 19%. If you make monthly payments of $250 then it will take you 64 months to payoff the debt and you will pay nearly $6,000 in interest alone! That is a huge cost.
If you compare a 19% interest rate with a hypothetical long-term investment return of 8% annually, then clearly the cost of your debt is much higher than what your money would earn you via investing.
Paying off the credit card debt is the equivalent to locking in a 19% rate ofreturn…and you aren’t likely to find a guaranteed return like that with any investment!Once the high interest rate debt is paid off as quick as possible, you can direct that money toward your investments.
Now consider your mortgage. Let’s assume that yourecently refinanced your home and have a low interest rate of 3%. If we again compare the cost of your mortgage at 3% to your projected annual investment return at 8% then it is likely more beneficial to put extra money toward investing rather than payingoff the mortgage sooner. The reason being that the money you invest is aimed at returning significantly more than the cost of your debt.
Consider your refinancing options
Refinancing can save you significant interest costs and allow you to pursue both paying down debt and investing.
Are you eligible for a new credit card with a 0% interest promotional rate? If so, it might be worthwhile to open a new card, transfer the balance and create a strategy to payoff the debt before the promotional period expires.
Word of caution –Do NOT open a new credit card if you are likely to build back up a balance on your old card.
Have you looked into refinancing your mortgage or student loans? With interest rates near historic lows, it is possible that you could benefit from refinancing the loan.
If you are considering refinancing your student loans then you first need to consider your current repayment strategy. For example, if you are on Public Student Loan Forgiveness then you should NOT refinance your loans as this will impact forgiveness eligibility.
What to do with large inflows of cash
Did you recently receive a year-end bonus or inherit money?
Consider using this extra chunk of cash to speed up both goals of paying down debt and investing.
Figure out how much feels comfortable to put toward your high interest rate debt versus investing. Again, don’t forget to compare the cost of your debt to your potential investment return. It may not be wise to put any of this money toward your mortgage, as your money is likely to work harder for you being invested in the market.
Investing may come with added benefits
Consider the benefits of where your savings are going.
Are you saving your 401k? Then you are not only targeting a certain rate of return on your investments, but you are likely receiving a tax deduction for your contribution, possibly a matching employer contribution and your investments grow tax-deferred
This enhances the benefit of directing money toward investing.
If you are years off until retirement, then you have the power of compound interest on your side. Compound interest is when your earnings are reinvested and have the opportunity to also earn you more money. This is an extremely powerful concept over long periods of time.
Put extra cash to use
You are likely aware that it is wise to have an emergency fund –generally 3-6 months’ worth of expenses at minimum, but sometimes more depending on your specific situation.
However, there can be a cost to holding too much cash. That is because money in a bank –even a high yield savings account –is earning very little interest and losing value to inflation over time.
If you are holding more cash than you need then consider how to best put that money to work –paying down debts or investing. Either one is likely to bea better financial decision than holding too much cash.
Determining whether to pay down debt or invest is a common question and one that involves both financial and emotional considerations. As you can see, it is a decision that is best considered within the larger financial strategy.
Take a look at what your interest costs are and compare that to what your investments might earn you. It is almost always better to pay off high interest rate debt as soon as possible, before the interest slowly erodes your financial situation.
Seek out guidance if you need assistance in making these financial decisions. A financial advisor can help you work through a situation like this, both from a financial standpoint and an accountability standpoint.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Jason Dall’Acqua, and all rights are reserved.