Should I put money into investments or pay off my debts? It’s a question that stumps the general populace. Most customers, sadly, don’t get much of an education in financial literacy. Instead, the majority of individuals need to educate themselves before making significant financial choices.
Among these choices is whether or not to begin investing now, or whether or not to focus on debt reduction first. Some people find the question to be as difficult to answer as catching a falling double-edged sword. The stakes are high, therefore you can’t afford to make a mistake.
What’s the difference between investing and debt reduction?
Interest and finance charges will increase if you only make the minimum payment on your loan. Furthermore, credit card debt with a high interest rate is very unpleasant. It’s difficult to receive a salary and then have to immediately put a sizable chunk of that money into monthly payments on a loan. It is unlikely that most individuals will ever be financially independent.
However, waiting too long to start investing might also have fatal results. Saving and investing for retirement is realistic.
The goal is to put your money to work for you in the market by taking advantage of compounding profits. Having a sizable nest egg will ensure that you may enjoy your retirement without financial worry.
Gains don’t have time to compound and establish a sizable retirement nest egg if you wait too long to start saving.
When compared to putting all of your spare income toward paying off debt, investing allows you to have a reserve for catastrophic costs.
Consequently, what is the answer? In most cases, this is a combination of making large payments toward high-interest debt and keeping up with the bare minimum on all other loans. Although you may not be fully debt-free, you can access the market as you pay off high-interest bills.
After all, the interest you pay on low-interest obligations like mortgages, federal student loans, and even some vehicle loans is likely to be lower than the return you might expect from prudent investments in the market.
How to Choose Between Investing and Paying Off Debts
In terms of money, everyone wants to do what’s best for themselves. If you make the proper choice, you may accelerate your debt repayment while also benefiting from the market’s compounding growth.
Effective debt reduction requires a thorough appraisal of both the interest you’re paying on your debt and the potential returns you could earn by investing that money instead.
If the interest rate on your debt is lower than the returns you could get from investing, then you should do the latter. If the interest on your debts is more expensive than the money you could gain by investing, then you should probably just pay off your bills.
But how do you calculate the opportunity cost of debt in comparison to the returns you could be generating on investments?
Step 1: Get Personal With Your Debts
You need to know the whole cost of your debts before deciding whether it is better to pay them off or invest the money. Interest rates are often what individuals consider when considering the expense of carrying debt. However, interest is not the only cost associated with debt; credit card debt in particular also carries yearly fees.
It’s also important to keep in mind that some creditors have one interest rate for a set percentage of the debt and a different interest rate for the rest of the money owed.
Lenders, Please Answer These Questions
Now that you have these sections completed, you may begin phoning your lenders to fill out the rest. There are a few things you should ask your lenders when you call them:
What Is My Account Balance?
Understand how much money is owed on each account.
What Is My Balance’s Interest Rate?
Use the exact wording of this question. If you are curious about your own personal interest rate, you may inquire. The representative may only disclose the purchase rate and not the default, cash advance, or balance transfer rates.
If you are being charged more than one interest rate on a single loan, you should treat it as though it were a separate debt and enter the sum owed at each interest rate in its own row of your spreadsheet.
Joe has a credit card balance of $10,000, $5,000 of which he transferred from another card at an annual percentage rate of 1.9%. The remaining $5,000 was acquired through expenditures at a rate of 19.99% per annum. Joe would have to enter this debt twice on his spreadsheet, once for the $1,900 at 1.9% and once for the $5,000 at 19.99%.
Is there an annual fee?
Even though they may seem insignificant individually, annual fees add up to a significant portion of the total cost of debt.
Are there any other fees or finance charges I must pay?
The agent must be honest with you about your financial situation. In this way, you may avoid any surprises when it comes time to pay off your obligations by asking this specific question.
Make sure you have a column to record any extra fees that may be incurred.
Step 2: Make an effort to reduce the cost of your debt.
By the time you’re done with your spreadsheet, you’ll have a clear picture of your debts and their accompanying expenditures.
However, before deciding whether to invest or pay off your debts quickly, you should investigate options for lowering the interest rates and fees linked with the money you owe.
The banking industry is always on the lookout for fresh client acquisition strategies.
Refinancing can help you save money on interest rates and fees on a variety of loans, including credit cards, auto loans, personal loans, and mortgages. Consider your current credit card balances first. It is possible to consolidate high-interest debts by transferring them to a balance transfer credit card with a 0% APR promotion period of 12-18 months, depending on your creditworthiness.
There’s a good chance you won’t be approved for a debt transfer credit card if you’re struggling to make your minimum payments. But it doesn’t mean you can’t get a discount of some kind.
Many credit card issuers have relief plans in place for customers who are struggling to make their minimum payments. You may get a handle on your debt and free up some cash with the aid of these programs, which provide very low interest rates and fixed payment schedules.
To assist their clients in making ends meet, financial institutions like Chase and Bank of America have lowered their rates to 0% for 60 months. Why? Because it is in their interests to do so. When filing for bankruptcy, debts may remain unpaid indefinitely.
So if you are having trouble making ends meet, it is time to start making those phone calls to your creditors. You should just be forthright about your financial predicament and explain why you’re asking for this loan.
You might find attractive refinancing deals for your mortgage or car loan by looking online. In many cases, you may lower your monthly payment and free up cash flow by refinancing your debt and negotiating a lower interest rate or longer repayment period.
Before taking advantage of a balance transfer credit card or refinancing offer, prioritize paying off your highest interest rate bills and revising your debt profile spreadsheet accordingly.
Step 3: Determine What You Can Expect From Your Investment
It’s time to investigate your investment options now that you have a firm grasp on the costs linked with your loans and have made measures to lower these charges. Part of it is figuring out how much interest you can make on your investments and comparing that to the interest you’re paying on your obligations.
But what if you are totally clueless when it comes to stocks? Should one even consider investing? Yes, it is the correct response.
First of all, reading articles is the simplest way to educate yourself on the stock market.
Second, automated investment services, such as Acorns and Betterment, are available. Do your homework first, though, because some advisers, both robo and conventional, provide greater average returns than others.
Stocks aren’t the only investment option, though. There has been a recent shift in millennial investing preferences toward real estate, which, depending on your objectives, might be a sound choice.
The average annual return on commercial real estate holdings was 9.4 percent, while the average annual return on real estate investment trusts was 10.5 percent, as reported by the National Council of Real Estate Investment Fiduciaries.
Investing in what you already know is essential, regardless of the strategy you select. You may, for instance, make a costly error in the real estate market by purchasing a home without first gaining a thorough understanding of the industry.
Similarly, if you want to put your money into the stock market but don’t know much about how new treatments go to market, investing in a clinical-stage pharmaceutical is a horrible decision.
Market analysis becomes a lot more doable if you put your money where your knowledge is. So if you know your way around automobiles, invest in automakers and get expertise in the field before branching out into anything else. Investing knowledge is a journey; one step along the way is to broaden your horizons and learn about investing in different industries.
You should conduct some homework to learn about the typical rates of return for the investment choices you’ve made. You may easily get the typical return rates by searching Google.
Your expected rate of return will help you prioritize which bills to pay off and which investments to make. The S&P 500 is often regarded as the most representative index of the U.S. stock market. It is a compilation of equities from different industries to provide investors a sense of the market as a whole. It is common practice for investors to evaluate their portfolio performance relative to the S&P 500.
The S&P 500 has returned an average of about 10% annually over the long run. As of late 2020, the S&P 500 has returned an average of 13.6% annually during the preceding decade, as reported by Business Insider. Keep in mind that returns can fluctuate greatly from year to year and that the market itself goes through cycles of growth and decline.
Step 4: Compare and Act
If you’ve gotten this far, you have a good idea of how much money you can make from investing and how much money your obligations are costing you. This leads us to our next step: contrasting the two.
Mark in red on your spreadsheet any debts whose interest rates are higher than the return you could expect from an investment. In other words, they are the overdue bills that must be paid immediately.
Sort these obligations by interest rate, with the highest rate being paid first. Keep doing this until all of your debts have been paid. The debt snowball strategy is a popular tool for attacking this problem.
You may make minimal payments on your bills while investing the money you free up as you pay down your higher-interest loans. You may now invest to generate positive returns, offsetting the costs of carrying a balance.
Say, for illustration purposes, you owe $900 on your mortgage every month at 4.25 percent interest, $200 on one credit card at 19.99%, and $125 on another at 17.25 percent. Also, each month, you have $1,700 to go either paying off debt or putting into investments.
To get started, put 17.25% toward the minimum payments on your mortgage and credit card. A sum of $1,025 per month would be required to cover the minimum payments on these two loans.
Even if they only ask for $200 every month, the remaining $675 should go toward paying off the credit card with the 19.99% interest rate.
Paying down your credit card will allow you to keep up with your $900 monthly mortgage payment. But now you can pay the $17.25 interest on your credit card balance every month.
Your credit card interest rate is far lower than the rate of return you may expect from investing, so once you’ve paid it off, you can continue making your minimum mortgage payment and put the other $800 toward your investment activities each month.
The keys here are knowing the typical returns on the investment vehicles you’ve chosen, paying off any obligations with interest rates higher than these average returns, and then investing aggressively once you’ve done so.
Bottom Line
This may seem like a time-consuming procedure, but for most people, deciding whether to invest or pay down debt first can be resolved in about two hours.
The method is straightforward. Pay off the bills with the highest interest rates first, and then start investing the money you freed up.
Simply check in once every three months to make sure things are moving in the correct way.
When it comes to the money side of things, don’t be reluctant to seek advice. While hiring a professional financial adviser will cost money up front, the benefits you reap from their expertise might well pay for the fee.
