If you are still wondering if you should invest or pay off your debt first, then this article is for you. It doesn’t matter how much money you are owing, everything will be tackled for you here and you will get started with the right answers. Firstly, you will have a sneak peek into the mathematical answer to this question. Afterward, you will be given questions you should ask yourself. That way by the end of this reading you will have an idea of a better answer for you.
The mathematical answer
Look at the interest rates of your loans, and compare the interest rates with the average stock market return. Determine how much money you will make if you put $1000 into the stock market. This is in comparison to using the money to pay off your debt.
Since 1926, the average stock market return has been around 10%, if you account for 2% inflation every year, you’ll be left with 8% returns yearly. The mathematical answer for this is that if your debt is below 8% then after making the minimum monthly payment, invest the extra. But if you have credit card debt that is often above 8% then focus on clearing the debt first before investing.
However, what the mathematical answer doesn’t account for are your finance and circumstances. This is why you will be answering a few questions to help you make the best decision.
What’s your plan to pay off your debt?
Do you have a plan to pay off your debt, everything in a shorter time frame? Or do you want to stretch out and tackle the minimum monthly payment for the next 10 to 20 years?. If you do have this plan to pay off your debt sooner then you’ll probably need to hold off on investing.
If you do not have a plan, then, you should create one. Take a good look at your debt, income, and expenses, then determine the day you want to be debt-free. When you do this, you will be in a better position to know if you would want to invest as you go. If the tenure for loan repayment is 10-20 years, it would be bad to hold off on investing. Since you’ll miss out on compound interest. If your payment years is a just a few years then you could sacrifice those years until you are fully debt-free.
Do you have an emergency fund?
An emergency fund is a money you have saved up in a high-interest account for rainy days. The rainy days are mostly if you lose your job, have unexpected medical expenses, or have natural disasters. Your emergency fund will be there as something you can fall back on.
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The thing is if you don’t have an emergency fund, you’ll be forced to take up credit card debts to fund those disasters. This brings you back to square one, buried deeply in debt. Therefore, if you do not have an emergency fund, open one, to give you a bit of financial security.
While you pay off your debt, that’s the minimum monthly payment, send the extra to your emergency fund. The emergency fund should be grown to have 3-6-9 months’ worth of living expenses in it.
What is your risk tolerance?
The most important thing to understand about investing is that there is no guarantee as there will always be risks involved. Even though the average return on the stock market is 10% no one can predict the market. With paying off your debt, you know that as long as you’ve paid off a $1000, you won’t be paying that anymore. But with the stock market, if you invest the $1000, it’s all gamble.
So are you okay with the risk that you might invest your money and the market works against you? Which would bring you back to the point where you needed to have an emergency fund? If all your savings are tied up in a risky investment portfolio you might want to sell at the bottom. But if you had an emergency fund to fall back on, you would be thinking rationally and not emotionally.
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In a good way, you need to have your hindsight spot on. Figure out if you should pay off your debt or invest using the current factors that you can control. These factors include first, how far away you are from your retirement. Secondly, what is your risk tolerance? Thirdly, the goal is to pay off your debt and on which date should you be completely free.
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What makes you happy and comfortable?
This question is often overlooked in personal finance but you must answer this. If it makes you happy to invest instead of paying off your debt maybe that’s your answer. On the flip side debt is an emotional thing and it tends to cause you stress and anxiety. It could bring shame, and regrets, and even affect your relationship. Debt makes you scared of being laid off in your workplace, and it bruises your ego.
When you do not have debt hanging around your neck, you wouldn’t be bothered about being laid off. So factor this into your decision, how does being in debt make you feel? And how would you feel if you didn’t have the burden of debt anymore?
Don’t let anyone tell you it’s a mathematical decision, it’s not entirely true. Ask yourself the four questions we tackled and find the right answer for you.