One of the biggest debates in finance: is it better to pay off debt or invest that money? The answer short answer is that it depends and in this article I will outline when it is better to invest the money and when its better to pay of your debts.
Before you start any calculations the best thing to do is make sure you have all the costs right for each strategy. People have a tendency to forget certain expenses that can result in a very different outcome.
First check the following for the money you wish to invest:
- What is your expected average return on investment?
- How long is your investment horizon?
- What is the tax rate on your investments?
Then make sure you have the following numbers for your debt:
- Interest rate
- Costs associated with early pay-off
- Any tax benefits for loans (such as for mortgages)
- Refinancing possibilities of the loan (can you refinance the loan with a lower interest rate)
Next to this you also want to know the following
- What is the average inflation?
- What is the average increase of housing prices in your area?
- Do you have an emergency fund?
- What costs or increases/decreases in income are you expecting in the future?
There are some other things you may want to consider besides profitability. If you do not have an emergency fund, fill that up first. If you do not have an emergency fund, you cannot invest. Emergency funds are there for when times are bad and generally that is also the worst time to cash out investments. You need the emergency fund in order not to withdrawal your savings or end up with even more debt. The conservative estimates state that you need to have 3x your expenses but it is recommended to have 6x your monthly income saved up and kept somewhere you can easily access it like a savings account. Also consider anything in the near future like income decreases (unstable job market, temporary contracts) or expense increases (baby coming soon, car/washing machine needs replacing). Inflation is also an interesting factor. Inflation can increase housing prices which can make refinancing for things like your mortgage interesting as you will fall in a lower risk category and thus get charged a lower interest rate. This can change your numbers and make investing more interesting. Inflation also often means that your salary increases with it and yet your loan stays the same value. If you country has a relatively high interest rate while income increases above or with inflation, it might also be worth it to wait and invest instead because investments profit from inflation. The last I want you to remember is ask yourself how well you manage your money. If you have trouble saving because you tend to spend your savings instead or if you have a history of debt issues, it is always better to pay off debt first. Debt can be a form of addiction and it is better not to test your willpower. Also, the decision between paying off debt and investing only works if, in the end, you still pay off your debt. Otherwise you just have extra costs.
After having your facts straight and considering the above, there is one very simple rule to decide if you need to pay of your debt or if its better to invest that money. It all depends on the cost of savings (the interest rate and any associated costs) and your return on investment (minus any investment costs and taxes). If your return on investment is higher than the interest rate, you should invest the savings. If your return on investment is lower than the interest rate you should pay off your debt.
Generally, credit cards carry the highest interest rate followed by any personal loans such as car loans or mobile phone loans. It is almost always more profitable to pay of these debts instead of investing. After these loans often come mortgage loans and the lowest form of loan is study loans. For these loans it is often more profitable to invest the money. If you have multiple debts, there are multiple strategies to pay off debt but I will discuss that in another article. If your general question is just should you invest or pay off debt than the best option is to first list your debt according to the interest rate and other costs you pay and then decide for each debt if it is higher then your expected investment return minus costs. Pay off the once where the debt costs are higher first, invest the rest.
Over the long term (30+ years), investments will outperform the interest cost of low and medium debt (5% or less). Generally young people (50-) have the investment horizon to invest while older people benefit more by paying off their mortgage. People who are willing to take more risk can also easier invest while people who prefer to be conservative and low-risk are better of paying of their debt considering some peace of mind.
If you want to begin begin investing but don’t know where to start, check out my other article How to start investing & Summary: The Little Book of Common Sense Investing. Want to learn more about money management? Choose one from this Top 10 books about money you nééd to read list.