Should I pay off my debts and loans or invest the money?
8 August 2006This is a common question – many people who are just starting out in life tend to have debts to pay off – student loans, maybe some credit card loans, a car loan, or whatever. They also know that they need to be investing money in the long run if they ever want to be able to retire. But which should come first?
The answer sort of depends on what kind of debt you have, and it also depends on whether you’re talking about investing money in general or investing it in a 401(k) or other tax deductable plan.
The general rule is: if the interest rate on the debt is over 10%, pay it off first. If not, invest the money first. The reason for this is that if you put your money in an index fund that mirrors the stock market, you can expect to make 10-11% per year on average. If you pay off your debt, your return is the interest rate on the debt.
This general rule means that things like your mortgage, your student loans, and your car should not be paid off – you should invest instead. Your credit cards, however, will probably have higher interest rates than 10% – and you should pay those off before investing.
BUT – there’s an exception, of course. What if you are talking about money that you would be putting into a 401(k), IRA, or other retirement plan where the money is tax deductable? Then, it’s probably better to invest even in the case of high-interest credit cards. You get an instant return equal to your tax rate – and the 10-11% return per year as well. Plus, your employer might match the money, in which case you’d be insane not to contribute.
BUT – There’s an exception to the exception. Sometimes your financial situation is so precarious because of debt that you should focus on paying it down first anyway, even if it’s technically a lower return. If you are living on the edge each month, with very little extra, your short term goal should be to get rid of small debts whose payments you can eliminate. If debts have made your budget so tight that you can’t survive a minor emergency, you should put off the investing. Focus on those debts, get rid of enough that you have a few hundred a month wiggle room in your budget, and then go back to the 10% rule.
Finally, I’ll admit that there is psychological satisfaction in paying off debts. I’ve violated the rule myself, and continue to do so – I know I’m not making the best return, but I really like the idea of not having a car payment or cutting down on the number of student loan bills I get every month. I’d probably pay off a mortgage early myself, just on the principle that when I retire, I want as few expenses as possible.
But there’s always an element of do as I say, not as I do – the smartest advice is to invest. And in my situation, I’ve got plenty going into the investments as well. So keep all these things in mind when making your decision.
Have a financial problem? Ask about it on the Free the Drones Financial Forums.
Comments are closed.