So you have some extra cash and have decided you’d like to use it to improve your financial life instead of spending it. Should you invest or pay off debt with it?
First off, congrats! What you should do depends on a range of factors, but either option is going to put you in a better spot than if you blow it on something you don’t need. So good job so far. Now, let’s define each side of the argument.
Investing vs Debt:
Investing represents money set aside to spend in the future. This means buying some type of investment vehicle – like stocks, bonds, or mutual funds – that will grow in value between now and when you sell the investment to spend the money.
Debt represents money that you’ve already spent in the past. A lender is charging you interest on the unpaid balance, for as long as the debt isn’t paid.
How to decide:
Like most financial decisions the best option is determined by looking at the math. And in this case it’s (at least on paper) as simple as looking at the interest rates.
Step 1: Determine the interest rate on the debts you’re considering paying off and compare them to the interest you’re expected to earn on the investments you’re considering buying.
Step 2: If you can earn more on your investments than your debts are costing you in terms of interest, you should invest the extra cash. If the interest on the debt is higher than what you’d earn if you were to invest the money, you should pay off the debt.
A clean example: If you compare a credit card balance at an interest rate of 20% and an S&P 500 index fund that’s historically grown by 10%, you should use your cash to pay off the credit card.
However, in the real world the decision is not often that simple.
For starters, the interest rate you’re “expecting” to earn on an investment is far less certain than the interest rate you’re certainly going to be paying on most debts. Take the S&P 500 index fund example above: Some years that investment could be either up or down as much as 40+%. If you’re comparing this to a debt with a fixed interest rate of let’s say 7%, how do you even do the math?
The general rule of thumb is to compare average returns on an investment and use that to make your comparison, but realize that fixed rates and projected returns are not at all equal.
To take this a little further, if the “average” expected return doesn’t far outweigh the guaranteed interest you’d be paying on a debt, it’s probably best to pay down the debt.
For example: Let’s compare the choice of either paying extra on a student loan debt at 7% vs investing in an index fund that’s historically earned 9%. Since these two interest rates are so close, the math starts to get close to equal either way and the right decision for you becomes more nuanced.
When the math is close, there are more factors that influence this debt vs investing decision than can be listed in an article.
If that’s the case, here are some of the positives of each side of the argument:
If the math is close:
The case for investing
If the interest rate comparison is close, the best argument for investing is that having investments gives you options and a version of freedom that paying down debts alone cannot provide.
Imagine two people side by side with a net worth of zero (net worth = all their assets minus all the money they owe).
The first person has $1 million of investments growing at 5% and $1 million of debt hurting her at 5%. Since the interest rates are the same, next month, year, etc. she will continue to have a net worth of zero without outside influence on the situation.
Now imagine person number two. She has $0 of investments and $0 of debt. Think of maybe a homeless person with nothing to their name. She will also continue to have a net worth of zero without outside influence.
The takeaway here is that not much financial freedom comes from the sole goal of paying down debt to zero. And that although there are many positives of paying down debt, that goal alone doesn’t do as much as what many people think it will. You must also build investments to create financial independence. In the example above, the first person has many more options in life than the second one, even though on paper they have the same net worth.
The case for paying down debt
If the interest rate comparison is close, the best arguments for paying down debt are:
- improving your credit score
- freeing up monthly cash flow
- sleep better at night by simplifying your finances.
Having a good credit score can help you in many ways, and your credit utilization ratio – the amount of credit you’re currently using compared to the amount of credit you have available to you – is one of the factors that influences your credit score the most. Paying down debts reduces the amount of credit you’re currently using, so as this ratio improves, your credit score goes up.
Once a debt is completely paid off, you obviously no longer have to make payments, which can create a real sense of independence by freeing up that amount every month for either investing for the future or spending immediately.
It seems like virtually everything these days is on either a monthly subscription or a monthly payment plan, which can create a feeling of being trapped by the next month’s bills. Paying off a debt completely is a great way to regain some of this independence, plus it simplifies your finances. And simplifying your life (in almost any area) is a way that many people find peace.
Most of the time, the best use of extra money towards your financial plan is as simple as comparing the interest rate of the debt with the interest rate of the investment.
However, if your highest interest rate debts are relatively close to the interest rate you’d earn on an investment (within 5% of one another) it’s best to look at the decision in the broader context of your overall financial goals and life situation.
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By: David Talley, CFP®