A lot of people find it complicated to decide if they should invest or pay debt. Many may compare the interest to be paid on debt compared to the rate of return that they earn on the investment.
For instance, you have a credit card with a $10,000 balance. Non-deductible interest on the card is around 17%. This means, the investment that you are thinking to make should earn you after tax return of over 17%. Else, it is better to pay the debt.
In real, it is not as simple as it seems because many factors (comparing interest rate is one) come into play when deciding between debt and investment.
Before moving onto that we must know the benefits of both – paying a debt and investing.
Benefit of paying a debt
There are many advantages of paying a debt.
A current debt keeps you off from borrowing more money. Paying the debt will open the window for you to take a loan in the future, and not suffer on the credit rating part. Financial institutions prefer giving loans to individuals with a reputation of paying all their dues in time. When thinking should I invest or pay off debts, don’t forget it!
Benefits of investment
Benefits of investment are known to all. It ensures a regular flow of income and gives you various types of taxation benefits. Also, investment can immune you from the inflation risk. An individual should plan investment that can be customized to the changing needs.
Related: Betterment, Vanguard and Wealthfront review
Now, you are ready to tackle the uncertainty over debt payment or investment. Following points will help you make a wise decision;
Understand the difference between ‘Good Debt’ and ‘Bad Debt’
Bad debt refers to a debt that has been taken to purchase assets that are depreciating in nature such as automobile, mobile phones and so on.
These items depreciate in value, and therefore, you are incurring double cost – depreciation cost and piling up interest on the debt payment. Even if you have an interest free loan for buying the item that is of depreciating nature, it will come under the bad debt.
On the other hand, good debt means, taking debt to purchase items that appreciate in value such as land, house and gold. Good debts can wait for a while, and thus, you can invest that amount instead of paying good debt.
Make a list to clear things out
Try to make a list of all the debts that is to be paid and the institutions from which you have taken these loans. Figure out the rate of interest and the minimum monthly payment for each debt. There will be some debts that can be paid of easily as the amount is less and the due date is near.
Of all the debts, do keep a good eye on the credit card debt. And, if possible pay it first, because the companies usually charge a very high rate of interest and also a huge penalty.
The idea here is to make sure that none of the debt is turning bad, and affect your credit score. For instance, there are institutions who exempt you from paying debt up to certain years, for instance education loan. However, someone with an auto loan will have to start paying immediately. It should not be kept pending, and must be paid to avoid penalty or late payment fee.
Risk Appetite
Level of risk appetite of a person also helps in thinking should I invest or pay off debt. Two important factors that determine how much risk someone can take are: Earning power and Age.
A young professional can take a risk of making investment and paying off the debt simultaneously because he/she has the capacity to work more and make more money.
Earning power refers to disposable income. If an individual has higher disposable income, then he/she might not have an issue in paying a debt, as well as, make investment together. If you have the capacity of making more money through aggressive investment as the debt obligation is less, then investment is always a better option.
Some debt is good for tax purpose
For some, the debt is so scary that they will go to any extent to pay it off. They will not shy once from taking out money from the retirement fund and paying the debt. However, this could prove to be one of the most ill informed decisions.
Experts say that keeping some amount of mortgage can render tax benefit.
If an individual takes money out of the retirement fund to pay the debt, then it will attract tax.
So, a better option would be to have a mortgage on the house and pay it regularly to get tax break, rather than pay tax on the retirement fund.
Source of income
Whether to put the fund in an investment instrument or pay off the debt also depends on the stream of income. Those who have a regular stream of income can afford to do investment now, and pay the debt later or vice-versa. However, if you do not have a regular source or fixed income, then prefer paying the debt first. Investment can wait.
The maximum downside of not putting the fund into investment is that you will incur the opportunity cost of not earning the return.
However, if you chose investment over paying debt, given the irregular source of income, the obligation to pay interest, as well as, the penalty incurred on late payment will keep on piling. Hence, warding off the debt interest payment is the better option for those who depend more on windfall gains.
Nature of investment
A question that you should ask yourself is, whether the investment that you are planning is to secure rest of the life, or you are doing just for the tax saving purpose? If the tax that you will save from making the investment is less than the interest obligation then consider paying the debt.
Expectation from the investment
Expectation from the investment
is another question that needs to be analyzed when you are deciding between investment and debt pay off. You should ask yourself – is the investment going to double the money, or it will just give a decent upside? Will that return be enough to pay the debts or will it be less than that?
If you are choosing an investment, it should generate return over debt payment and penalty payment obligation. An investment usually takes more than a year before it starts making money for you. However, interest on the debt will pile up in that one year. Therefore, the investment should atleast generate enough return to pay the actual interest and the penalty.
Balancing both – the best way
Most feasible solution (if you can) is to keep paying off the debt, as well as, invest. Start with keeping aside small amount for investing along with setting automated payments for paying off the debt. Although, some of us pay off the interest regularly, not everyone is firm determined to pay as it comes. Setting automated payment will ensure that you are not skipping on the interest payment, and not paving way for late payment fee.
On the other hand, investing small amounts via Systematic Investment Plan (SIP) and other such investments could give you significant benefits in the future. Such investments will not create any unnecessary pressure, even if you are paying the debt.
Cash Cushion – don’t forget this
Many believe that before investing or paying off debt, you should create a cash cushion of at least six months. This cash cushion should cover all your monthly expenses such as maintenance, utility bills, and tuition fees (if you have kids going to school), minor health issue cost and so on. Calculate all such items of monthly expense to create a cash cushion, and the balance left after that should be directed towards the investment or paying off the debt.
I hope you’re smarter now when thinking should I invest or pay off debt 🙂