People who find themselves with extra cash may face a dilemma. Should they use the money to pay off – or at least, to pay off substantially – that pile of debt that they have accumulated, or is it more beneficial to put the money to work in investments that will prosper for the future? ? Either choice may make sense, depending on the circumstances.
Key points to remember
- Investing and paying off debt are two good uses for any spare money you may have.
- Investing makes sense if you can earn more on your investments than your debt is costing you in terms of interest.
- Paying off high interest debt is likely to provide a better return on your money than almost any investment.
- If you do decide to pay off your debts, start with your debts with the highest interest rates and work from there.
Investment vs. debt repayment: main differences
Investing is a way to put money aside for the future, ideally in an investment vehicle, such as stocks, bonds, or mutual funds, which will increase in value over time. Debt, on the other hand, is money you’ve already spent that a lender charges you interest on. If left unpaid, this debt will grow and rise, with interest charges adding to your balance and causing interest charges in and of itself.
The case for investing
Generally, if you can earn more interest on your money by investing it than your debts are costing you, then it makes sense to invest. For example, if you have a mortgage with an interest rate of 5% and a stock index fund that earns 10% per year, you will earn by investing your extra cash in the index fund.
(On the other hand, if you have 20% credit card debt, you’re better off spending your extra money on paying off that debt rather than investing it in the index fund.)
Unfortunately, it’s not always that simple. Investments can be volatile. This index fund could be up 10% this year, but down 10% next year. While there are investments that pay a guaranteed interest rate, such as bank certificates of deposit (CDs) and US Treasury bills, they tend to have low rates of return that rarely exceed rates of return. interest charged by credit card companies and other lenders.
Another factor is more psychological: your risk tolerance. If you are comfortable taking the bet that your investments will fluctuate with the markets, sometimes rising and sometimes falling in value, then you are a better candidate to invest than someone who would stay awake overnight. worry about what the market might do tomorrow.
The case of debt repayment
There are several good arguments for choosing to pay off debt rather than investing. The first, as mentioned above, is that you could come out a winner if your debt carries a relatively high interest rate. This is especially true with credit card debt. The average credit card interest rate recorded in Investopedia’s credit card database was recently 19.62%. Few investments can match this rate of return.
Another good reason to pay off debt is your credit rating, a number that can be very important if you want to borrow money in the future, such as a mortgage or a car loan. Having a low credit score can mean paying higher interest rates if you can get a loan. Your credit score can even affect other aspects of your life, such as the premiums you’ll pay for insurance, whether a landlord will hire you, and even whether an employer will hire you.
Credit scores are based on a number of factors. In the case of the most used score, the FICO score, your credit utilization rate – the amount of credit you are currently using versus how much credit you have – is an important part of your score. So, for example, a person whose credit cards are all maxed out is likely to have a significantly lower score than someone whose credit cards have been paid off or at least paid off at a more reasonable level.
Paying off debt, especially if you have a lot of it, can be a smart move for this reason alone.
As with investing, psychology comes into play here as well. If you are losing sleep over your debts, you might be better off paying them off, although you might get a better return on your money by investing.
The case to do both
Paying off debt versus investing doesn’t have to be a choice decision. You can, and sometimes should, do both. For example, if you don’t have an emergency fund yet, you can use some of your money to create one, while using the rest to pay off your debts. A good place to keep your emergency fund is a low-risk, highly liquid (that is, easily and quickly accessible) investment, such as a money market mutual fund.
How to pay off debts
If you have decided to use your available money to pay off your debt, the next question is how to go about it. If you have enough money to cover everything you owe, the answer is quite simple: just pay. However, if you don’t have that much cash to spare, you’ll need to prioritize.
Generally speaking, you get out of debt faster if you pay off your debt with the highest interest rate first and later. For example, if you have balances on two credit cards, one charging you 20% and the other charging 15%, address the 20% balance first.
In the case of credit card debt, you may also have another option: transfer your balances to a card with a lower interest rate and then pay them off. Some balance transfer credit cards offer promotional periods of six to 18 months, during which they charge 0% interest, which can help you pay off your balance faster since you won’t incur additional interest. . Investopedia publishes regularly updated reviews of the best balance transfer credit cards.
Yet another option is a debt consolidation loan from a bank or other lender. The way it works is that you borrow enough money from the lender to pay off your other debts. Now you only have one debt to worry about, ideally with a lower interest rate than your previous debts. You can then use your extra money to start paying off that loan. Investopedia also publishes ratings of the best debt consolidation loans.
If you are really in debt
If your free cash is not starting to reduce your debt, you may need to consider more drastic measures. First, if you’re having trouble making even the minimum monthly payments on your credit cards or other loans, contact your lender. He may be willing to lower your minimum payment or the interest rate on your debt.
A second option is to hire a reputable debt relief company to handle the negotiations for you. This is an area full of scams, so make sure you know who you are dealing with. As the Federal Trade Commission notes, “These transactions often charge a large upfront fee to cash-strapped consumers, but do not help them settle or reduce their debts, if they provide a service at all.” Investopedia publishes annual ratings of the best debt relief companies.
The bottom line
Having extra money is an enviable situation. Investing that money or using it to pay off debt is a decision that only you can make. But either use is better than just spending it. No matter which course you take, you’ll be in better financial shape than ever before.