Finding out how to put your extra money to work is not always as clear cut as you think. Many people believe that paying their debts off first is the best use of their funds, while others feel that investing money into something currently has a greater opportunity for growth than simply paying down their existing debts. Ultimately, the right decision for you will depend on your current debt level, the maturity of your loan product, your risk tolerance and your overall long-term financial goals. Money decisions are not always black and white and can often be emotional in addition to being situation-specific.
Assuming you have money available to you (in cash behind your TV) and you want to decide whether to use that money to pay off your debts or invest in the stock market, the total amount in question can provide some insight on how best to make that choice. Paying off debt results in much more predictable growth of your money compared to investing. For example, if the current interest rate you are charged by your credit card is 18% then paying down your debt equates to literally earning an 18% guaranteed rate of return on your investment with very little or no risk whatsoever if you choose to pay your debt.
A mental advantage is also present. Less debt equals decreased stress, fewer payments to make each year, and more room to breathe. Thus, Mental Peace might be of more value than any future return on investment you could make.
Why Investing Could Be the Better Long-Term Play
Investing is great when you have time on your side. If you look at long-term trends in the stock market, particularly over 10-20 years — the trend has always been upward. Therefore while short term returns can vary widely, if you give compounding interest time to work for you then building your investments will provide a positive return.
If you have a low interest rate debt (like a four to five per cent mortgage), you may get higher long-term gains by investing rather than paying off the loan early.
An Important Issue to Consider: Taxes and Risk
Most investment gains will be taxed, thus your actual investment returns may be different than what you see on paper. On the other hand, paying off a loan means that you do not have any tax liability thus the savings are entirely yours and guaranteed.
Risk is also important. There are risks associated with all investments. Conversely, there are no risks involved with paying off debt. For this reason, if you prefer stability rather than volatility, paying off debt may be perceived as being a safer alternative.
Real-World Examples That Alter Answers
You may want to focus on paying down your credit card debt first if it’s high-interest; this will give you a guaranteed value of return better than any investment in the stock market would provide realistically.
If you have moderate student loan debt, how soon will you pay them off? Paying down the loan faster than expected is a good idea, but if it takes you many years to repay them (which means that you can’t do anything with the money), you may want to think about putting some money into investments instead.
If you only have an adjustable-rate mortgage (ARM), you may be able to put away some more money for extra cash flow by investing in the long run, as opposed to making additional mortgage payments on your ARM right now.
Why Personal Finance Is Personal
This isn’t only a mathematical issue; it will also be a function of your stress tolerance, lifestyle, future career goals, and how you view investing. For example, an individual who has a stabilizing income and long-range financial goals will invest more aggressively than an individual who wants to simplify their financial life and achieve financial freedom.
The amount of time you have to repay your loans is important; the amount of income you could make over time is critical; your level of risk associated with those investments plays a role.
A Balanced Approach (Concluding Thoughts)
If debt is a short term and high-interest, pay it off as quickly as possible.
If debt is a long term and low-interest, you may benefit more from investing instead of paying off the debt.
If you are someone who really dislikes having financial stress, then paying off your debt may have an immeasurable emotional value.
If you are focused on building wealth for the future, then investing should be an important part of your strategy.
Finding Choice & Growth
Being free of debt offers tremendous peace of mind, whereas investing allows you to build wealth for the future. While both of these options will ultimately produce different outcomes based on when you intend to use either strategy; neither is superior to the other. The best way to determine what is the best choice for you will depend on your individual circumstances and not on someone else’s idea of what they should do.
