Did you know that the total household debt in the US at the end of 2017 was $13.15 trillion dollars? This is an all-time record and includes mortgage debt, credit card debt, student loans, and so on. This was the fifth consecutive year that the US household debt had been on the increase. “A man in debt is so far a slave” is what Ralph Waldo Emerson said in the 19th century, and it still holds true today. With recent fluctuations in the global economy, more and more people are unwillingly deciding to get loans, which pulls many of them into a debt cycle.
However, in spite of that, some of the people facing debt still decide to invest instead of paying down their debt. If you are wondering “Should I invest or pay off debt?”, you have come to the right place. Here you will learn the ways to assess your debt, strategies to pay off debt as well as whether you should invest or pay off debt first.
- Common reasons for debt
- Paying off debt vs. investing
- Know your debt
- How to pay off debt
- Plan your financial freedom
Common reasons for debt
There are numerous causes of debt. And as if all this wasn’t enough, both banks and credit card companies are trying to come up with new ways to make people indebted. The most common reasons for debt are:
- Low income – If you earn less than you need in order to afford the most basic amenities, you will very likely end up taking a loan.
- Bad budgeting – Maybe you earn decent money, but you are not very good at planning how to spend it. This is the road that leads to debt.
- Unexpected event – This might be a divorce, illness or death of someone close. In all of these situations, you will need help from professionals whose services might require that you take a loan.
- No savings – This point is directly associated with the previous one. Always have some money on the side. You can never know what tomorrow brings.
- Gambling – Unless you have a lot of extra money to waste, don’t gamble.
- Spending in advance – Don’t rely too much on your credit card. Wait until money is actually on your account.
Paying off debt vs. investing
When you invest a certain amount of money in P2P lending, for example, you expect to make a profit in the long run. The borrower pays back your money plus the interest rate, which, depending on the loan, can be lower or higher. When you invest, you hope that the $500 you have invested will become $600 after a certain period of time. But “hope” is the keyword here. Even though investing is mostly safe nowadays, there are still examples when investors don’t get their money come back. The more risk you take, the more likely things can go wrong.
On the other hand, when you pay off debt, you know for certain that you are improving your financial situation. With each of the monthly payments that you make, you are making a step toward a better future. When paying off debt, you know that you can get rid of it by paying $500 now instead of $600 in a year. This is a great way to avoid accumulated rates and practically make a very wise investment if you are in debt.
That is the exact reason why paying off debt gives a better risk / reward ratio and a guaranteed return on investment. Simply put, to pay off debt is the best way to invest in your financial future.
Know your debt
However, you should differentiate between different types of debt for not all of them require to be paid down instantly. This might give you leeway to invest and earn some extra money that will help you pay off your debt later on. To know whether you should pay off debt or invest first, you should play a numbers game ‒ but an honest one.
The best way to do this is to compare the rate of after-tax interest on your debt and the expected after-tax return on your investment. Basically, if you can save more money by paying off debt than you can gain by investing, you should pay off your debt first. On the other hand, in case you can earn a high return on investment, you might want to take your chances and invest your money instead.
Good debt vs. bad debt
Even though each debt is bad at its core, we want to differentiate between good and bad debt. Good debt is the money that you borrow at a low interest rate. It helps you make a high rate on return. Examples of good debt are borrowing money to buy an apartment which you will later rent or starting a business that will make you money.
On the other hand, bad debt is the debt that is most common among people, and that is consumer debt. This is the money that you borrow at a high-interest rate and use it to buy something that doesn’t make you any money (a car, clothes, etc.). If you have any bad debt, you should start paying it off before even thinking of investing.
When deciding whether to invest or pay off debt, there are a number of factors that you need to take into account. You should consider your income, age, earning power, tax situation, time horizon and other criteria unique to your particular situation. On one end of the spectrum, there is a young person with a high disposable income and great tax situation. They should definitely take a risk and invest because they have a higher risk tolerance. Also, someone who has urgent healthcare costs needs to pay for them instead of paying down their debt.
However, a person who is approaching their retirement and has average income should take the safe path and pay down their debt before doing anything else. At the end of the day, your decision depends on your personality. Apart from the aforementioned factors, which are all external, try listening to your gut. If you like taking chances, invest. But if you like to play it safe, then pay off debt first.
How to pay off debt
Now that you know why you should you pay off bad debt before investing, we are going to share some tips to pay off debt. You probably want to know how to pay off debt fast but you need to know your situation before you actually choose a specific strategy. These strategies are not one-size-fits-all. Some of them will work for some people, while others will do wonders for consumers facing a different situation.
If you have a debt with a rate which is higher than any investment return could ever be, what should you do? According to the debt avalanche strategy, you should pay down the debt with the highest interest rate first. This kind of debt falls under the category of bad debt that we previously mentioned. Credit card debt is the best example of bad debt since it has the average rate of 15% and doesn’t give you any return. Here is how to pay off credit card debt:
- Create a plan to pay off credit card debt
- Use credit cards only when you have to
- Pay off credit card debt first
- Cut down on your expenses to have more cash
- Use savings to pay the debt off
Because of its high rate, it is wise to eliminate this type of debt as soon as possible. On the other hand, you might want to consider whether you should pay down your mortgage simply because its rate is way below credit card debt rate ‒ usually between 4% and 5%.
Debt snowball is a useful debt reduction method which has helped many people owing on more accounts get out of debt. In a nutshell, it works like this:
- First you pay off the accounts with the smallest balances while trying to make minimum payments on larger debts.
- Once you are done with the smallest debt, you focus on the one slightly larger and continue to pay the minimum on really large debts (if you have any).
- Proceed with this strategy until you have paid all your debt.
Even though nobody likes loans, especially refinance loans, sometimes they are necessary. When choosing such a loan, you should consider numerous factors, such as your credit score, debt-to-income ratio, interest charges, APR, lender’s credibility and so on. An essential piece of advice is to beware of predatory lending. You can definitely avoid these lenders and find much better solutions. Many people, even with bad credit scores, take loans to pay off debt and do it very successfully. If you act wisely, you will have success too.
Save to pay
If you have a job and want to pay off debt, it is wise to have a minimum of six-month worth of monthly expenses in cash. This amount of money creates a financial cushion that will get you through any unexpected difficulties in spite of the fact that you are paying your debt. Also, if you run your own business, you simply must have this cash if you want to keep the business going during hard times.
Plan your financial freedom
Paying off debt is one thing but being financially free is an entirely different story. Here are the steps you should take on your way to financial freedom.
Ironically enough, getting rid of your debt is the first step to financial freedom. You can’t actually be free if you owe money, and we don’t mean this just in a financial sense. Being in debt leads to negative thoughts, stress accumulation, uncertain future and many more unwanted outcomes. That is why the first and most important step for anyone owing money is to become debt-free.
Stick to your budget
You should treat budgeting as an integral part of your financial journey. Whether you are in debt or have money to burn, planning your financial steps is essential. Decide what your priorities are and what are the things that you can go without. This way, even if you have to unexpectedly spend money on something, it will not disbalance your overall financial situation. If you want to avoid debt, you should never spend more than you can afford.
Make decisions wisely
This point is a direct result of the previous one. Even if you do have a plan for your budget, it might be loaded with wrong decisions. To make wise decisions, you should consider many aspects of your finances and life in general. Things to take into account are:
- Your vision of future self
- Your career opportunities
- Growth opportunities
- Sustainability of your long-term goals
With all these in mind, you can keep things in perspective and be wise when it comes to planning your finances.
Whatever you do, make sure you put some money aside whenever you can. This will enable you to afford to make any investments or cover unexpected spending without having to apply for loans or credit cards.
Finally, investing is one of the best things you can do to create a carefree financial future. There are a number of ways to invest your money wisely, for example through robo advisors. Other investment opportunities to consider are investing in real estate, stock market, mutual funds, etc. It may take time to become successful at investing but once you gain the necessary experience, you will see how easy it is to make a substantial return that can give you a secure financial future. Wise investments are crucial for long-term financial freedom.
Conclusion: Paying off debt vs. investing
Having read this entire article, paying off debt before investing makes perfect sense, doesn’t it? This goes especially for the so-called “bad debt”, i.e. the debt that you pay off at high rates but which gives you no ROI at all. Depending on your particular situation (income, age, type of debt), you can choose one of many strategies to pay off debt. Debt avalanche, debt snowball, saving money or getting a loan can all be helpful, you just need to figure out the best method for you. If you want to pay off your debt, there are always ways to achieve this goal.
Then, once you are debt-free or even while paying down your debt, you can start building a sound plan for financial freedom. If you make wise decisions in this process and thereafter, you can rest assured that you will have a bright financial future. What are your thoughts on paying off debt? Please let us know in the comments.