Debt is typically an unavoidable part of living a normal life. Common reasons to borrow money include buying a home, buying a vehicle or getting a college education.
Borrowing to improve your life for the better or increase your future salary can be a smart move. However, it is easy to say that too much debt is not good and people are getting carried away.
The average American is encumbered with $38,000 of personal debt (not including mortgages) according to Northwestern Mutual’s 2018 Planning & Progress Study.
Invest, Save or Pay Off Debt?
Many Americans are working towards becoming debt-free but you should also have a plan to save and invest.
Aggressively paying down debt is the quickest way to get yourself out of the red, but must you always use extra cash to pay off debt? The answer depends on the type of debt you have and your financial goals.
Saving for an Emergency Fund Should Be Your First Priority
Even if you have high-interest debt you should use any extra cash to build an emergency fund, if you do not have one. Make the minimum payments and save up for 3 months of living expenses.
An emergency fund will keep you from getting further into debt if something happens. It may be tempting to rid yourself of high-interest debt before saving, but you could end up getting stuck in a debt cycle.
Having an emergency fund will allow you to rely on yourself, instead of credit cards. Less reliance on debt will help you break free from living paycheck to paycheck.
Once you have a minimum of 3 months of living expenses saved you can look into paying down debt or even investing.
High-Interest Debt Can Cost You a Fortune
Once you have an emergency fund, its time to decide if you should continue to save, invest or pay down debt. If you have any debt with an interest rate of 7% or more, it’s better to use extra funds to pay it off.
Most individuals won’t earn more than 5-7% on investments, so you will get further ahead if you just pay off high-interest debt.
A simple interest loan of $5k and an interest rate of 11% will end up costing you $7,200 if paid back over 4 years. If you make additional payments and pay it off in 2 years you’ll save $1,100 in interest!
Not All Debt Should Be Paid off Early
Debt with typically low-interest rates like mortgages, auto loans and student loans don’t need to be aggressively paid down. Any extra funds you have after making minimum payments could be better off invested in the stock market.
The historical average return of the S&P 500 is 10% while the average interest rate on a mortgage is 3.99%. You don’t have to be an expert to see why it makes sense to invest instead of making additional payments on low-interest debt.
It’s Not Always Simple
There are some things that you need to consider, the stock market is volatile and involves risk. Your investments are not guaranteed to be safe, especially if you’re investing for less than 10 years.
If you want your money to be safe, a savings account only earns on average 0.09%. The safety of a savings account earns much less than the interest you’ll pay on any debt. If you cannot invest for at least 10 years, you’re probably better off paying down any and all debt first.
Paying off an auto loan (even with a low-interest rate) could better than investing depending on your preference. Vehicles depreciate in value and need regular maintenance. If you’re making minimum only payments on your car you could end up getting upside down in the loan.
Personally, I would pay off all debts besides a mortgage or low-interest student loans before investing. After the debts are paid down you can increase your cash cushion and start to invest aggressively without worry.
When it comes to debt, you’ll always want to make the minimum payment on time no matter what. This will keep your credit in good standing and prevent financial doors from closing.
The decision to pay off debt early, save more or invest your spare money is entirely up to you. Think about your financial goals and do the math.
What’s right for one person can be completely wrong for you. For instance, if you are saving up to purchase a home, you’ll want the funds to be safe and obtainable. The down payment will be better off in a high-yield savings account rather than being invested in stocks.
A market downturn could wipe it out at the exact moment you plan on purchasing a home. On the flip-side, if you don’t plan on buying a home for more than 20 years, you’ll earn a much better return investing in the market.
A professional financial advisor can be worth visiting depending on your knowledge and current situation.
The most important part of managing your money is that you are the one making the final decisions. After all, it’s your money and it’s your livelihood.