Received Extra Cash? Should You Invest or Pay Off Debt?
Have you come into some money and now face the eternal conundrum: Pay off debt or invest? That's a tough one, but you do have options.
Invest or pay off debt… Pay off debt or invest?
The choice can seem excruciating, especially if you have a deep desire to prepare for your financial future and wipe out debt once and for all.
Do these scenarios sound familiar?
Sarah has $5,000 in student loan debt and $5,000 in credit card debt. In addition to these debts, she has a car payment and a mortgage. She has trouble making ends meet and has decided that she just doesn't have any extra cash to sink into a 401(K) or Roth IRA.
One of Sarah's relatives dies and leaves her with $10,000. She thinks, "Wow, that's just enough to pay off student loans and my credit card debt. But I haven't gotten started investing at all — I've been working for five years and have never set up a retirement account."
What should Sarah do?
Or maybe you can relate to this one:
Caleb has been investing for years. He has $90,000 in student loan debt from his stint in medical school. He pays just the minimum on his student loans because he believes he can make more money by investing in the stock market and it's more advantageous to do that rather than pay off his loans. He gets a $10,000 windfall and puts it all into the stock market.
Should Caleb have chosen to do that instead of pay off his student loans?
Here's the deal: Ultimately, what's right for you may not make sense for someone else. In this example, Caleb has already moved down the path of investing in lieu of paying off student loans, while Sarah seems paralyzed with indecision.
Let's take a look at some things you may want to consider in your own personal situation.
How to Decide Whether to Pay Off Debt or Invest
If you've come across some money, use the old pro and con trick to decide which will benefit you the most.
Reasons to Invest Instead of Pay Off Debt
Let's take a look at the pros and cons of investing before focusing on paying off debt.
- You can take advantage of compound interest. Investing money in the market can benefit you in the long run. Putting money in the market early on can make a major difference in how much you end up with at retirement or a number of years down the road. In general, if you believe it's more important to pursue a higher return on your investments than the interest rate that you pay on your debt, you should consider investing. You also might not want to spend so much time on paying down debt that you miss the chance to take advantage of what happens in the markets over time.
- The interest rate on your debt might be low. The current average mortgage rate on the 30-year fixed-rate mortgage is 3.03%, which is really low by a lot of standards. You might reason that you can earn more in the stock market (10% on average over the past century) and may opt to put a priority on investing instead.
- Consider investing to protect yourself. What if you got in a car accident, suffered a serious injury and could no longer work or if your spouse died at a young age, leaving you to raise young children. Preparation might come with investing and coming up with income streams instead of continuing to pay off debt.
Reasons to Pay Off Debt Instead of Invest
Let's take a look at the flip side. If you can't stomach the thought of keeping debt hanging around, you're not wrong to consider that angle. Consider the reasons to pay off debt instead of putting a priority on investing:
- Debt is psychologically challenging. When you have excessive amounts of debt, it might be all you can think about. Wiping out debt can offer better mental benefits (and even physical benefits!).
- You save on interest. Let's say you have a $10,000 credit card balance and have an APR of 18% on your credit card. You can arrive at your minimum payment and amount owed using a simple calculation: $10,000 balance x (0.18 APR / 12 months) = $150. You owe $10,150. Imagine if you continue to add increments like that onto your amount each month. Yikes.
- You may retire earlier. Research shows that a reduction in mortgage debt since age 62 comes with lower bill-paying difficulty and lower levels of ongoing financial strain in retirement.
- It helps your credit score: When you pay off debt, it boosts your credit score, which can help you qualify for things you want, such as that beautiful house you've always ogled in your neighborhood.
- You build a stronger relationship with your spouse or partner: Your spouse or partner will thank you for restoring equilibrium to your relationship. Debt has a tendency to force apart relationships, and numerous studies have proven that fact.
Reasons Why You Might Want to Consider Doing Both
There's a third option here: Investing and paying off debt at the same time. The option has long been popularized by many experts and it's also completely viable. It's fair to take a look at the possibility of saving and investing at the same time.
You can balance both goals. You might not feel quite right about focusing on just getting out of the red or just investing. Doing both can allow you to feel as if you're making progress in both directions: your financial goals (like saving for retirement) and working to eliminate debt at the same time.
What Did You Decide?
Guess what. There's no wrong answer here. The beauty of personal finance is that it's personal. You can make a decision better than anyone else for your own life because nobody has the exact same goals and dreams as you do. As long as you factor your investment goals and time horizon into all the angles that you consider, you're unstoppable.