Should I pay off debt or invest?
Today we’re going to talk about the controversial topic of pay off debt or invest?
The fundamental question is should you pay off your debt first or should you take that money and invest it?
Debt is bad
Debt sucks! Debt is the worst! There’s definitely good debt and there’s definitely bad debt.
In general, most people don’t want to have debt.
Debt is like a big weight on your shoulder and it always lingers on in your conscience.
It’s this constant nagging factor that is holding you back from your future endeavors.
You want to take that vacation but you’ve got that debt, you want to pursue something but yes you’ve got that unpaid debt.
In summary, debt can create a psychological barrier.
Debt definitely can add a lot of stress to your life.
In fact, debt can also create marital problems. Over 59 percent of divorces has some kind of financial component to it.
Good vs. Bad Debt
Since I touched on good vs bad debt, let’s discuss a few examples of each for illustration purpose.
Some entrepreneur wants to leverage debt in order to build their business.
There’s an ongoing debate on the differences between good debts and bad debts.
You may have heard that you needed debt to get a good credit score.
Your credit score is an important piece of your personal financial health. You do need debt to build credit.
However, you do not need to be chin high in debt in order to achieve a strong credit score.
One of the easiest ways to do so is to use a credit card. The rule of thumb is that you should only have a balance of 30 percent or less each month.
You’ll also need to pay off your bill on time and in full each month since credit card balances is considered bad debt.
What is Good Debt?
According to the Motley Fool, good debt is defined as financing something that will appreciate in value in the future.
- A mortgage
- Student loans
- Small business loans
- Real estate investment
These are considered good debts because there is a potential for return.
For example, since you don’t have the full amount to pay off your house upfront, a mortgage allows you to eventually own your house outright and reap the benefit when the value of your house appreciates.
A student loan will lead to an education or skill that leads to a higher paying job or an increase in your current salary.
And finally, your business loan can help you jumpstart a profitable business venture.
What is bad debt?
Bad debt is defined by the Motley Fool as financing something that will not return your investment.
- Payday or title loans
- Credit card debt
- Auto loans
- Personal loans
An auto loan is oftentimes categorized as bad debt because cars do not appreciate in value. In fact, a car’s value will depreciate in value over time.
You can the case that an auto loan is a good debt since you need your car to get to work and earn an income.
Good debt versus bad debt has a lot of grey area.
One potential mistake is to justify your debt as good debt just because it has leverage.
If you over-leveraged, a bad market such as a recession can cause havoc to your financial well-being.
The bottom line is, know how much you need, borrow just enough and have a sound repayment plan in place before taking on that debt.
Should I pay my debt off or invest?
One of the main arguments to invest in that one can earn let’s say a 10 percent return of investment (ROI) by investing the same amount used for paying off debt.
On the other hand, let’s say your student loan is charging you an interest of 6 to 7 percent annually.
By investing, you’ll earn an extra 3 percent instead of paying off your debt.
On the other hand, if you’re in the paying off debt first camp, you’ll argue that paying off debt first is a guaranteed ROI of 6 to 7 percent.
Furthermore, that 10 percent rate of return is in a good market condition.
Did you experience the downturn of the market in 2008? During that period, investors lost 40 to 50 percent of your investment over the course of the year.
The point is, the market will fluctuate and your average return may not be 10 percent. It may be much lower.
Another argument for investing first is taking advantage of the employer match if your company offers 401 (k) and an employer match.
Conventional wisdom will tell you that you’re leaving money on the table if you’re not contributing at least enough to get the company match.
I agree with this point. You should at least try to get the employer match. This is generally a good idea.
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One financial rule of thumb I learned from The Broke Millenial Book on Investing is that if your debt is less than 5 percent, then it makes more sense to invest rather than paying off your debt.
In order to make an informed decision of whether to pay off debt first or invest, let’s answer a few basic questions.
What are your financial goals?
This is a personal answer, you might want to aggressively save and invest in order to retire early.
Or you just don’t care! One of the tenets of personal finance is that it is “personal.” There is no right or wrong, it is all up to you.
Most people fall into the middle ground. Where you’re still working your 8 to 5 jobs and is relying on traditional modes of savings for your retirement.
In this case, it is best to pay off your debt first rather than focusing on investing.
Once your debt is taken care of, this provides peace of mind. You no longer have those weight on your shoulders and have a good financial foundation on which to build on.
Once your debt is paid off, then you can kick your investment and savings into full gear.
What is your time horizon?
When making a case to weigh the pros and cons of paying off debt or invest, your age and how long you’ve got until your desired retirement age is an important factor.
If you’re young, time is on your side. Compound interest, which is defined as when your money grows over time from market appreciation and dividend reinvestment, will have more time to work its miracle.
Keep in mind that you don’t have to go one way or the other with paying off debt and investing.
You can choose to do a hybrid approach, where you’re paying off some of your debt and at the same time, putting some money toward investing and saving for your retirement.
There are a number of online calculators available to simulate compound interest, but for illustration purposes, if you invest $5,000 from the age of 21 until 65, at a 7 percent interest, you’ll end up with approximately $1.4 million dollars.
What is your investment plan?
This sounds like it’s common sense question but another factor that comes into play in your decision making to invest or not is that do you know what you’re doing?
I don’t mean to be condescending but you’re not born with financial know-how. You have to learn how to invest. If you’re iffy about your investment skills, then you can focus on paying off debt first and take the time to learn how to invest properly.
It’s probably best to not pour all of your money into your investments until you fully grasp the concepts and come up with a sound investment plan.
Finally, do you have enough money?
We debate all day long about whether it’s best to pay off debt or invest but it’s all moot if you don’t have the funds to invest!
I can word this a little differently, are you ready to invest? Did you pay off your high-interest debts i.e. student loans, credit cards?
Do you have an emergency fund? Note, most experts such as Dave Ramsey recommend to have an emergency fund of 3 to 6 months of your monthly expenses.
It’s generally recommended by financial experts that you do the above things first before you focus on investing.
So should I pay off debt or invest? This decision should be based on careful analysis and considerations. You have to know your financial goals, understand the concepts of time horizon and compound interest, and make the appropriate preparations.
Debt can be good or it can be bad.
A good rule of thumb is to pay off high-interest debts first. These high interest debts are your credit card, auto loans, and student loans.
Low-interest debts are debatable, it can go either way. However, it’s important to make sure that you’re ready to invest. Aside from first tackling your debt, you have to build up an emergency fund.
You may want to consider opening a high yield savings account to store your emergency fund or other reserve funds.
Next off, depending on your investment needs, you may need to save some money. For example, if you want to invest in real estate, you need to save up to 20 percent for a down payment.
You may also need to save enough money to open a brokerage account. In this case, a low-cost Robo-advisor may be a good option for you to get started.
At the end of the day, I like the hybrid approach. It’s important to start investing when you’re young. But it’s also important to chip away at your debt.
What is your answer to the question of investing or paying off debt first?