“Should I invest or pay off debts first?” It’s a question that challenges the masses. Unfortunately, the vast majority of consumers don’t learn much about financial literacy in school. Instead, most people must educate themselves before making tough financial decisions.
One of these tough financial decisions is deciding whether or not it’s time to start investing or if it’s better to get out of debt first. For many, the question is like trying to catch a double-edged sword as it falls to the ground. Making the wrong move can have serious consequences.
Taking too long to pay off debts means paying more in interest and finance charges. Plus, debt is uncomfortable. When you get your paycheck and you know you have to shell out a decent portion of it to pay back money you’ve borrowed, it can be stressful. Many people feel like they may never reach financial freedom.
But taking too long to start investing can have similarly serious consequences. Investing makes retirement possible. The idea is to take advantage of compounding gains in the market, allowing your money to work for you. That way, you’ll have plenty of money to get you through your golden years.
However, if you wait too long to start investing, gains don’t have time to compound and create a meaningful retirement nest egg. Investing also helps you maintain a reserve for catastrophic expenses, while focusing all your excess funds on paying off debts leaves you without an emergency fund.
So, what’s the solution?
For most people, it’s a mix of aggressively paying off high-interest debt and making minimum payments on the remaining debts. As you pay off the high-interest debts, you can reallocate the funds to tap into the market.
How to Decide Whether to Invest or Pay Off Debts First
Everyone strives to make the right financial decisions. In this case, making the right decision means you get out of debt quickly while taking advantage of compounding gains in the market.
To do that most efficiently, it’s critical you develop a detailed understanding of the cost of debt and the gains you could experience through investing. If debt costs less money than the gains you can realize in the market, it’s better to invest. If investing would make you less money than you would spend on the cost of your debts, paying your debts off is the right way to go.
But how do you acquire an understanding of the overall cost of debt and the amount of money you could be making through investing?
Step 1: Get Intimate With Your Debts
Before you can decide if it is more advantageous to pay off debts or invest, it’s essential you understand every cost associated with your debts. When we think about the cost of debt, we often think about interest rates. But some types of debt — credit card debt in particular — also come with annual fees.
It’s also imperative you remember that some creditors charge one interest rate on a percentage of the balance and another interest rate on the rest of the money owed. The first step is to build a spreadsheet that lists everything you need to know about your debts. Here’s an example:
|Lender Name||Lender Phone Number||Lender Address||Account Number||Balance||Interest Rate||Annual Fee||Additional Fees|
|Example Debt 1||555-555-1234||123 Main Street||123456||$300||21%||$0||$0|
|Example Debt 2||555-555-1235||1234 Main Street||123457||$1,000||12%||$0||$0|
|Example Debt 3||555-555-1236||1235 Main Street||123458||$12,000||9%||$100||$0|
The sheet is relatively simple. There are six columns of data to fill out for each lender. Start by filling out the lender name, lender phone number, and if readily available, the lender address columns for all of your debts.
Once you have these columns filled out, start calling your lenders to fill out the rest. When you call your lenders, there are a few questions you need to ask:
- What Is My Balance? You need to know exactly how much money you owe each lender.
- What Is the Interest Rate on My Balance? Make sure you ask this question as written. If you ask, “What is my interest rate?” the representative may tell you your purchase interest rate without informing you of other interest, such as default rates, cash advance rates, and balance transfer rates. If they’re charging you more than one interest rate on any given debt, act as though each interest rate is a new debt in your spreadsheet, filling out a new row for each balance at each interest rate. For example, Joe has a credit card with a balance of $10,000, $5,000 of which accumulated via a balance transfer at a rate of 1.9% annually. The other $5,000 came from purchases at an interest rate of 19.99% annually. On his spreadsheet, Joe would have two lines for this debt, one line item for the $5,000 at 1.9%, and one line item for the $5,000 at 19.99%.
- Am I Paying an Annual Fee? Annual fees, while generally small, factor into the overall cost of debt.
- Am I Paying Any Other Fees or Finance Charges? The representative is required to tell you the truth about your debts. As such, asking this question ensures that you cover all the fees associated with your debts. If there are any additional charges, create an additional column that allows you to track them.
- Is It Possible to Reduce My Interest Rate? Few lenders will openly tell you you qualify for a lower interest rate. However, you can sometimes reduce interest by simply asking. That often depends on who your lender is and how your relationship has been through the term of the account.
Step 2: Work to Reduce the Cost of Your Debt
Once you have your spreadsheet filled out, you have a detailed view of the costs associated with your debts. But before you can decide whether it’s time to invest or aggressively pay off your debts, you must first look for ways to reduce the costs associated with the money you owe.
Lenders are constantly looking for ways to bring new customers in. From credit cards to auto loans, personal loans to mortgages, you may be able to save on finance costs by refinancing.
First, think about your credit card debt. You can sometimes roll high-interest debts into a balance transfer credit card at 0% interest for a period of between 12 and 18 months.
But before transferring any balances, there are three things you need to know about your balance transfer card:
- Balance Transfer Fees. The days of the feeless balance transfer are long behind us. In most cases, balance transfer credit cards come with a fee of between 3% and 5% of the total balance transferred. So before moving forward with a transfer, compare the fees associated with the transaction across multiple offers.
- Standard Interest Rates. Once the promotional periods on balance transfer credit cards are over, they charge the remaining balances at the standard interest rate. So make sure you know what the rate is before transferring a balance.
- Annual Fees. Finally, some balance transfer credit cards come with exorbitant annual fees. In general, avoid balance transfer credit cards with annual fees. However, in some instances, the rewards justify high annual fees.
If you’re having a hard time coming up with your minimum payments, you probably don’t qualify for a balance transfer card. However, that doesn’t mean that you don’t qualify for a reduced interest rate.
Many credit card lenders offer financial hardship programs to help those who are drowning in debt. These programs come with very low interest rates and fixed payment plans, helping you gain control of your debt while freeing up funds for other financial opportunities.
Banks like Chase and Bank of America have reduced interest rates to 0% for 60 months to help their customers make ends meet. It’s in their best interest to do so. Debts that end in bankruptcy can go unpaid forever.
So if you’re having a rough time paying the bills, start calling your lenders and asking them for help. All you have to do is explain your financial situation and simply be honest.
It’s also important to consider opportunities that can reduce the cost of your auto loan or home loan by searching for refinancing offers online. By refinancing your debts, you can often reduce interest or extend the term of your debts, ultimately reducing your overall monthly burden and opening available funds.
If you do take advantage of a balance transfer credit card or refinancing offer, use it to pay off high-interest-rate debts first and update your debt profile spreadsheet once you have.
Step 3: Understand What You Can Expect From Investing
Now that you have a strong understanding of the costs associated with your debts and have taken steps to reduce these costs, it’s time to take a look at what’s available to you in the world of investing. A vital part of that is understanding how much money you can earn by investing to compare it to the amount of money that you’re losing through your debts.
But what if you know absolutely nothing about the stock market? Is investing even a good idea? The answer is a resounding yes. First and foremost, learning about the stock market is as simple as reading articles. Second, there are robo-advisors like Acorns and Betterment that can do all the work for you. But make sure to do your research before you start, as some advisors, whether robo or traditional, generate average returns that are better than others.
The stock market isn’t the only way to invest, either. Lately, there’s been a trend of millennials pushing for real estate investments, which depending on your goals can be an effective option. According to the National Council of Real Estate Investment Fiduciaries, commercial real estate properties had an average annual return rate of 9.4%, with real estate investment trusts returning an average of 10.5% annually.
No matter how you choose to invest, it’s crucial to invest in what you know. For example, if you know nothing about real estate, buying a property and blindly trying your hand in the market could be a painful mistake. Likewise, if you choose to invest in the stock market, investing in a clinical-stage drugmaker is likely a bad idea if you know little about the process of bringing new medications to market.
By investing in what you know, analyzing your opportunities in the market becomes much more manageable. So if you know cars, invest in car manufacturers and learn through experience before venturing into other options. As you learn how to invest, start learning about other sectors to diversify your portfolio.
Once you’ve figured out which investment options are best for you, do a little research to get an understanding of the average return rates you can expect using the options you’ve selected. Finding average return rates is as simple as asking Google what they are. Once you know what your average return should be, you can better understand what debts you should pay off before you start to invest.
The S&P 500 is the benchmark stock market index of the United States. It is a list of stocks across various sectors that provides investors with an idea of how the market is doing overall. Investors tend to compare their returns to the S&P returns to gauge how well their investments are doing.
According to CNBC, as of 2017, the average return the S&P 500 had generated over the previous 90 years was 9.8%. Of course, it’s important to remember that the market has its ups and downs, and from year to year, average returns can vary wildly.
Step 4: Compare & Act
If you’ve made it to this step, you now know how much money your debts are costing you and how much money you can make through investing. Now, it’s time to compare the two.
On your spreadsheet, highlight the debts that cost you a larger percentage of the balance than you would make if you were to invest. These are the debts that need to go quickly. Now, arrange these debts from highest interest to lowest and send all extra funds to the highest-rate debt first. Continue this process until you’ve paid off these debts. This process is commonly called the debt snowball method, illustrated by this useful spreadsheet and guide from iHeartBudgets.
As you pay off your higher-interest-rate debts, you can make minimum payments on your debts and put the funding you free up into investments. You’re now able to make more money through investing than you lose by having balances.
For example, let’s say you have a mortgage debt with minimum payments of $900 per month at 4.25% interest, one credit card with a minimum payment of $200 per month at 19.99% and one credit card with a minimum payment of $125 per month at 17.25%. You also have $1,700 per month to use toward debt and investing activities.
In this case, start by paying the minimum payment on your mortgage and your credit card with 17.25%. These two debts would come with total minimum payments of $1,025 per month. The remaining $675 per month should all be sent to the 19.99% interest rate credit card, even though they only require $200 per month.
Once you’ve paid off that credit card, continue to make the minimum $900 per month mortgage payments. But you can now send $800 per month to your 17.25%-interest-rate credit card. Once you’ve paid off that credit card, you can continue making minimum mortgage payments and use the remaining $800 per month to put toward investing activities, as the interest on your mortgage is far lower than the rate of return you can likely expect through investing.
The keys here are making sure to know the average returns on the types of investment vehicles you chose, aggressively paying off any debts with higher interest rates than these average returns, and aggressively investing once you pay off these high-interest-rate debts.
Quarterly Financial Health Follow-Ups
Once you have a plan set and you’re on the path to financial freedom, don’t fall off course. Simply complete this process quarterly to make sure things haven’t changed with regard to your debts.
Also, take some time to review the returns on your investments. If you’re not reaching your goal return, restructure your investments into other investment options that may yield more significant gains. If you’re not comfortable making investment decisions without a broker, speak to a financial advisor or use a high-quality robo-advisor.
Everyone wants to make it to financial freedom. However, the only way to make it is to be diligent and know what your money is doing for you at all times.
Pro tip: Personal Capital has a feature called the Financial Roadmap. The goal is to provide you with customized, actionable, and timely advice to help you succeed financially.
While the question of whether you should pay off your debts or invest first seems like a tough one to answer, the entire process takes less than a couple of hours for most people. The process is simple. Start by getting an understanding of your debts and your investment options and use this newly procured knowledge to aggressively pay high-interest debts off and invest once you’ve reached that goal.
Just remember to take a look at what’s going on quarterly to be sure everything is going in the right direction.
Also, don’t be afraid to ask for help when it comes to the investing side of the equation. Professional investment advisors do charge fees, but the knowledge they bring to the table has the potential to far outweigh the additional cost through increased returns.
Have you used a process like this to decide which debts to pay off before investing? Do you have any tips to add?