The following is presented for informational purposes only.
Which is better, paying off debt or investing your money? There’s no quick and easy answer to this question. The decision involves some comparison between what your debt is costing you and what you expect to make in return for your investments. It also involves taking a close look at your financial situation.
When deciding between debt repayment and investing, here’s what you need to consider:
Do the math
Just like everything else in your finances, deciding how to best use your money is all in the calculations. Take a look at your debt and calculate exactly how much it will cost you to pay it off. Be sure to include any interest, fees, and penalties into these calculations. It’s important to get a clear picture of your debt so that you can make the best decision for your finances.
Try using the debt calculator over at Credit Karma. It’s a handy way to see how much your debt is costing you, and how much you can save by increasing your payments.
Next, take a look at your after-tax rate of return on any investments you may be considering. Unless you’re investing in a tax-free bond or a tax-sheltered account, you will most likely need to pay taxes on your earnings, which could decrease your actual return, so keep that in mind.
Since the question is whether to repay debt or make an investment, you want to compare two numbers: the difference between the cost of your debt (primarily interest charges) with this hypothetical additional payment and the cost of your debt without any extra payments; and the potential return on your investments.
We want to know if putting this pool of extra money into debt will save us more money than it could earn as an investment. That’s not the whole story, of course, but finding those two numbers will help provide an objective, numerical baseline for your decision.
Examine your financial situation
If you’re carrying a lot of high interest credit card balances, paying off these debts may be the better way to go for now. Paying off those debts will not only save you money (that you can later invest), it can also help improve your credit score. If you’ve been struggling to balance your finances because of debt payments and building strong credit is a priority for you, then debt repayment is definitely the smart option.
If your debt is manageable and your interest rates are low, however, investing some of your funds might be a wise option. Especially if those investments are part of a long-term savings plan and you manage your risk.
Before making the final decision though, it’s wise to make sure you have ample emergency funds set aside. When it comes to investing, the funds you set aside are usually difficult to access, at least for a period of time. And if you have to withdrawal those funds early, it may come with a penalty that could eat into your returns.
Consider another option
There’s one other option you can consider and that is finding a middle ground. Use some of your funds to pay down debt, especially the high-interest loans, and some to invest. This way you can achieve both goals at once. Budget for paying down your debt with as much as you can manage each month so that you can get it paid off faster and avoid interest fees. Then start investing by taking advantage of your employer’s savings plan, like a 401(k), where your employer matches some or all of your deposits. This way you can deposit twice as much into your investment account while still paying off those heavy debts and increasing your credit score.
When it comes to making a decision to repay debt or invest, look at all options, do the calculations, then make the decision that works best for your financial future.
If you need more help understanding how to tackle your personal debt, consider speaking with a certified credit counselor. Counseling is free and includes an objective review of your finances, along with suggested resources and next steps to help you reach your goals.