Maybe you’re sitting on a little debt, but you are also aware that if you want to see your money grow it’s a smart idea to start investing. You might be left asking a common question: Should I invest or pay off debt first?
Many investors ask this question at some point in their lives. You want to start seeing that nest egg grow, but the monthly payments on your debt feels like an albatross around your neck. Will you ever get rid of it? Do you even need to get rid of it? The answer, like the answer to so many of life’s questions, depends on your individual situation. However, there are some general guidelines to help you through this puzzle.
Not all debts have the same effect on your long-term financial health. Those that are best paid off quickly are the ones termed consumer debt, such as credit cards or the loan from the furniture store where you bought your new sofa. These are sometimes called “bad” debts. Why should you look to paying these off quickly? These debts generally carry fairly high interest rates, higher than the return you would see on an investment. So if you invest $300 every month instead of paying down that $8,000 credit card balance, you are losing money because the gains from your investment won’t cover the continuing interest on the credit card balance.
While these loans are also a form of debt, and must be repaid, they are not considered to be “bad” debts because you, theoretically at least, you’ll reap a financial benefit in the long run from them. Student loans will increase your earning power and mortgages eventually lead to ownership of the property.
So, is it better to pay them off before investing? Possibly not. This is one of those areas where your personal situation and current financial obligations will influence the answer. However, the interest rate on these loans is typically much lower than that on a credit card, so the right investment may earn more than your monthly interest payment on the loan. Interest paid on both student loans and mortgages is also tax deductible, so that may influence your final gain or loss.
Many people accept the fact that payments on these types of loans are just a part of their monthly budget rather than trying to pay them down early. Especially with student loans, paying down the principle won’t decrease your monthly payment. In addition, in the case of a mortgage, if you use all your free funds to pay it down, you run the risk of making the property your only investment. This, as any financial adviser will tell you, is not a good idea. Your investments should always be diversified in different areas of the economy.
Most financial advisers think it is a good idea to have an easily accessible emergency fund that is not tied up in investments. The usual recommendation is enough to cover three to six months of your regular expenses, such as housing, utilities, food, transportation, and payments on existing debt. How much money you need in your fund will vary depending on your current job security, which can be influenced by how long you have held the job and the volatility of your job’s sector of the economy. However, this is often an intensely personal decision based on what makes you feel comfortable. Do you want a minimum amount in order to free up funds for investment or do you want the security of a larger amount of emergency savings?
In the end, whether or not hold off on making investments until you are debt free is a personal decision only you can make. Many investors find that some combination of debt and investment works best.