Unless your last name is Buffett or Kardashian, you are probably carrying more debt than you’d like. And you also need emergency and retirement savings. So, how do you decide how much income goes toward debt repayment and how much for investment?
You’ll need to ask yourself a few questions.
Invest or Pay Off Debt: How to Decide
The decision to invest, pay off debt or do both is highly individual and depends on your personality and circumstances. The answers to these questions can help you set your own financial path.
1. What do you earn on investments?
The most basic rule of thumb when deciding to invest or pay off debt is that you pay debt when the interest rate is higher than what your investments are earning.
If you’re not sure, you can go with averages—the average rate of return over the long-term for a typical diversified portfolio is about 7.5%. For example, rental properties can generate appreciation plus rents and have operating costs. A good property calculator can help you determine your return.
You can also look up the exact returns on your individual investments. When looking for these numbers, base your decision on the expected rate of return, not what you earned last year or this year-to-date. Many stock funds, for instance, are quite volatile. You might earn 20% one year and lose 18% the next. But you should be able to see that fund’s five-, 10- and even 20-year return by checking with its management or a site such as Morningstar.
2. What do you pay in interest?
Your decision is very different if your debt consists mainly of a mortgage with a 3% interest rate and a car with a 5% rate than it is if you owe mainly credit card debt at 20%. Very, very few investment vehicles generate a return that exceeds average credit card interest rates.
3. How are your investments and debt taxed?
You shouldn’t ignore the tax implications of your debt and investments. If your credit card debt is business-related, you can deduct your interest. Or if you consolidate debt with a home equity loan or cash-out refinance, your interest may be tax-deductible. That lowers the cost of your debt.
If your investments are tax-exempt or tax-deferred, that effectively increases your return. And actively managed investments such as rental properties have a lot of tax implications. Make sure to adjust your return and cost to reflect any special tax treatment for items such as depreciation, investment interest expense and operating costs.
4. How is your risk tolerance?
Not all returns on investment are equal—even if they are equal. That’s because investments don’t come with identical risk profiles. In general, the higher the return, the greater the risk. That’s why you should look at long-term returns or expected returns when evaluating investment versus debt. Those figures incorporate risk and help you make better decisions.
Paying off high-interest debt such as credit card balances is almost risk-free, while any investment paying double-digit returns is likely to be pretty risky and could easily backfire.
Risk tolerance is about more than your personality. It’s about where you are in life. For instance, if you’re fresh out of college and qualified to take a great job in a high-paying industry, you can afford to take more risk. You’re young enough that you’ll be able to weather peaks and valleys without having to withdraw your funds at a bad time. That may tip the balance toward investing. You can also use a tool like M1 Financing, which combines automated investments with customizable stock portfolios if you want to diversify your portfolio without a minimum balance or annual fee.
But if you’re looking to retire in a few years, you should not be taking crazy risks with your money and should favor safe vehicles delivering reliable dividends or interest. You won’t have time to make it back if your portfolio has a bad week, or month, or year. That may push you toward debt repayment or investing smaller amounts in things such as penny stocks, where each share costs less than $5.
5. Do you have an emergency fund?
Many personal finance specialists recommend saving an emergency fund before embarking on debt repayment or long-term investing. That’s not just because of unforeseen catastrophes such as the coronavirus pandemic. Even a $400 mishap could snowball to horrible consequences. If you cannot repair your car to get to work, you could lose your job. If you can’t afford an emergency medical procedure, you might risk your health or even your life.
So, it’s really important to have emergency savings. If you’re a salaried employee in a stable industry and you’ve worked for the same company for a few years, save enough to cover at least two months of bills. If you’re in a less-stable industry or are self-employed, shoot for at least six months of bills.
Note that you just need access to enough money to cover your emergencies. That can be savings, a line of credit, or a combination. If you need to cover six months of bills and that comes to $12,000, you might apply for a credit card with a $5,000 limit, a personal line of credit with a $5,000 limit, and save $2,000.
Once you are covered with an emergency fund, you can create your investing or debt reduction strategy.
6. How good are you at managing your spending?
One big factor for or against debt repayment is your debt management skills. If you can’t control your spending, some strategies such as debt consolidation can backfire in a spectacular way.
You might take a home equity loan, balance transfer card or personal loan and zero out your credit card balances. But then you run them back up again because you have not solved the problem that causes you to overspend in the first place, So, now you owe the debt consolidation creditor as well as your credit card issuers.
If your spending is out of control or you are in serious financial trouble, you need more help than this article can provide. You should absolutely be focusing on debt reduction but in a way that won’t turn on you.
Consider a reputable, non-profit credit counseling service and a debt management plan (DMP). And if you can’t pay off your debt under the plan in five years or less, check with a bankruptcy attorney. It might make sense to wipe out your debts in bankruptcy court or through a DMP and then start investing after your debts are gone.
How to Save an Emergency Fund
The key to saving an emergency fund is budgeting. Go through your spending over the last two months and note where your money went. Divide your spending into fixed necessities (such as your rent or mortgage), variable necessities (such as food, utilities and gas), and discretionary items (such as entertainment, food eaten away from home, vacations, etc.).
Try to trim variable necessities by at least 5%. Choose cheaper brands of food, combine trips or carpool, shop your insurance policies and watch your lights and thermostat.
Try to cut discretionary spending by at least 10%. Opt for less expensive restaurants, or add more free options to your socializing. Playing softball with friends or having a picnic can be as much fun as brunching or retail therapy. And you skip the hangover (financial or other).
Get creative—for instance, you have to live somewhere. Buying a home instead of renting may allow you to invest without substantially increasing what you spend on housing. Especially when you may be able to buy a home with little or even nothing down.
How to Pay Off Debt Faster
In most cases, it makes sense to prioritize debt reduction over investment. If that describes your situation, there are several things you can do to get your debt situation under control so you can then focus on investing.
If your debt is mainly high-interest credit card accounts, consider the waterfall method for debt reduction. With the waterfall method, you target the account with the highest interest rate. Make the minimum payments on all other accounts, but throw as much money as you can at the most expensive card. Once that balance has been cleared, take aim at the next-highest rate. Every time you zero out a card balance, you’ll have that much more income to pay the remaining balances until they are all gone.
If your credit rating is good, you may be able to reduce your interest expense and speed up your debt repayment with a balance transfer credit card. These accounts charge no interest for up to two years. Every cent you pay goes toward paying down your balances. While you’re in the interest-free period, it’s smart to pay as much as you possibly can. Note that there is a fee for transferring balances; usually it’s about 3 percent.
Debt consolidation offers a few advantages. You can simplify your life by replacing several debt payments with one. You may be able to lower your costs by reducing your interest rate. And you may be able to drop your payment by getting a better rate and also by extending your repayment.
Note that extending your repayment term does increase your cost, while accelerating your payoff decreases it.
You can consolidate debt with a personal loan. One advantage of a personal loan is that it’s an installment loan. You cannot run your debt back up after you pay it down like you can with credit cards. You zero out your cards, close them out, take out a loan — say, for three years — and at the end of those three years, your debts are gone.
Alternatively, you can consolidate debt with a home equity loan or cash-out refinance. That should sharply reduce your interest rate and payment. Debt backed by a home is less risky to lenders and carries the lowest rates available. And the long repayment terms allow you to drop your payment in a significant way.
How to Invest While Paying Off Debt
In most cases, you should get some emergency savings (or credit) together and then focus almost entirely on debt repayment. That’s because almost all consumer debt carries higher interest rates than most investments pay.
But there are exceptions. If you consolidate your debt to a low-interest cash-out refinance or home equity loan, your after-tax cost may be lower than the return on your investments. Consolidating to a low interest rate and low payment is one way of getting debt under control (if you have a history of managing your debt well and not overspending) while freeing up cash for investment at the same time.