Is It Better to Pay off Debt or Invest? The Answer May Surprise You.
While it may seem like an uncommon situation, there will come a time in most peoples’ lives where they must decide whether to use their money to pay off debt or invest. In this article we’re going to break down why you may want to pay off debt before investing or not.
Here’s a common dilemma people face when they receive a large amount of money at one time – should I pay off debt or invest the money?
As you may imagine, there’s no catch-all answer here. Let’s take a gander at some of the points of consideration.
When should you pay off debt before investing?
The first thing to consider is how having debt affects you personally. You could be the kind of person who lives a carefree existence despite having a mortgage, auto loan, and 2 maxed-out credit cards. On the other hand, you might be someone who can’t sleep at night because you borrowed 20 bucks off your best friend. Debt affects us in different ways.
If even a moderate, manageable amount of debt stresses you out, then you’re probably better off eliminating that worry from your life as soon as possible. Stress leads to a whole host of health problems, and your health should always take precedence over making some extra change.
If debt is something you can live with yours is at a financially manageable level, then it may be better to invest instead of immediately paying off debt.
How much debt do you have?
The most important factor here is the amount of debt you have and the frequency that you’ve agreed to pay it back. Your debt should be manageable – that is, you’re able to pay it back on time and can still afford your other living expenses. If you’re having to take out loans to cover loans, then you probably need to pay off a chunk of it. This quickly brings us to…
What type of debt do you have?
When answering whether or not it is better to pay off debt first or invest, short term debt with high-interest rates should always be a point of focus. After tax, will you make more interest from an investment than the rate you’re paying for your debt debt?
Mortgages are a useful example here. Current estimates show that around 60% of American homes have a mortgage on them, making it one of the most common types of debt. When people receive a significant windfall, such as inheritance money, it’s natural to consider paying off your mortgage – but does it make financial sense to do so?
Let’s take a look at the figures. Let’s say you take out an average mortgage of $250,000, of which you wisely put down the standard 20% deposit ($50,000) and have an outstanding balance of $200,000 to pay. Let’s say it’s a 30-year mortgage at a fixed interest rate of 3.5%. That would mean you’d be paying back around $900 a month for the next 360 months, which would bring you to a total of $323,312 in debt.
Now paying over $120,000 in interest alone certainly sounds like a great reason to pay that mortgage off ASAP if you’re able to. However, looks can certainly be deceiving. What if you invested that money instead of paying off the debt immediately?
This is where things get interesting. Let’s say you invested your $200,000 in an investment that would net you 5% a year, which is a reasonable rate of interest. Assuming you reinvested the profits each year and didn’t add anything else, it would take you only 9 years to earn $325,779 – already slightly more than the 30-year mortgage total. How about if you reinvested over the whole period? You’d be looking at a whopping $864,388.
Of course, this is assuming that everything went according to plan each year. It doesn’t factor in things like the fees you’ll pay on the investment, nor any taxes you may be liable for. However, even if fees were 1% of the total invested, you’d still be looking at $648,680. This makes a great argument for investing before paying off the debt doesn’t it?
So what should you do?
It’s very much up to you. You need to consider your specific financial circumstances and personal tolerance for debt and risk when deciding whether to pay off your debt before investing. Remember, there’s no such thing as a risk-free investment. You should never invest money that you can’t afford to lose, and you should always understand the terms and conditions you’re signing up for.
The more you develop your financial literacy, the more confident you can be about the decisions you make with your money. Regardless of whether you choose to pay off debt or invest, we advise you to make the decision based on careful consideration.
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