Americans began 2020 with an accumulated credit card debt of $3 trillion, so don’t feel alone when you find yourself with high-interest debt to pay off.
But, the stock market is also raging at all-time highs. Do you pay off your debts or invest?
Both have their advantages and their limitations. If your debt is high, the conservatives will always tell you to tackle your debt first. But is it necessarily the best option? The answer is complex, and it hinges on each individual’s financial situation. When considering whether to pay off your debts or invest you should consider these questions first:
What Is Your Financial Baseline?
A straightforward way to assess your financial baseline is to create a budget to see how your monthly income is divided. Experts recommend the 50/30/20 approach:
- 50% for necessities
- 30% for optional expenses such as recreation and entertainment
- 20% for savings and debt repayments
Make sure you have first built up an emergency fund and resolve any past-due debts that affect your credit rating. Then, you are ready to calculate the amount of money you may set aside to pay off your debts or invest.
Look at Your Debt APR Compared to Your Projected Investment Interest Rates
Look to your considered investment interest rates to the APR (Annual Percentage Rate) debt interest rates. If you expect a yield on your investment that is lower than your interest rates, it is advisable to pay off your debt first. Credit debt interest averages far higher than lower-risk investments, and so it makes sense to pay it off first.
If the annual percentage rate of your debt repayments is at a lower interest rate than your projected returns on your investment, then it makes sense to invest.
Payday and title loans have high-interest rates and these should always take priority over investing. Be careful of comparing just interest rates and not APR rates because the APR reflects the full cost of the loan, including fees and sundry charges.
Why Investing Is a Good Move?
- Your money will grow — Most investment securities offer returns on your initial investment over time and, unlike savings which are useful for future needs but provide no actual income and no increase in your original amount.
- Build a retirement — You may invest in a variety of ways such as stocks, bonds, mutual funds, real estate, or precious metals to ensure that you may have a nest egg for your planned retirement.
- Earn higher returns — Investment vehicles offer a higher return than a savings account.
What Are the Key Investment Types?
Certificates of Deposit (or CDs) and US Treasury Debt
Experts consider CDs and US Treasuries the safest forms of investing. They are referred to as fixed-income investments and deliver slow and steady returns at a slightly higher rate than your average savings account. The FDIC, NCUA, and the American government protect these investments.
With these forms of investments, as the risk increases so do your returns increase correspondingly. One can invest in blue-chip companies like Apple (AAPL) or Microsoft (MSFT) or even Bank of America Corp. (BAC.)
These reputable firms pay investors in the form of dividends, which are payments made by a company to its investors and are usually a means of profit distribution.
Alternatively, one may invest in new companies, and instead of dividends accrue wealth through the appreciation in the value of shares.
Companies may issue debt to investors to fund new investments or operations in the form of corporate bonds. These types of bonds carry a higher risk than treasury and municipal bonds, so the interest on these bonds is higher.
The company will provide investors with periodic interest and return the principal amount to the investor when the bond matures. Rating agencies usually will provide these corporate bonds with a rating with AAA being the most secure and anything below BBB holds a greater risk
Local governments and agencies may issue debt to fund municipal operations and specific projects in the form of bonds. These municipal bonds carry less risk than corporate bonds and have the bonus of tax advantages, but these advantages are most beneficial to high-earning investors and the long-term returns are relatively low.
Mutual funds collect money from a group of investors and use it to buy securities such as stocks or bonds. Investors may buy a share of this fund, operated by a mutual fund company. One can purchase these shares from the fund company or a broker only.
ETFs are like mutual funds in that they pool money from investors and invest it in securities. Investors can’t purchase ETFs from the holding company, but one may trade them on market exchanges.
What Is Risk Tolerance?
Risk tolerance reflects the investors’ ability to take risks when investing and they should take many key factors into account such as
- Period of investment
- Individual tax situation
Younger investors have more options to take high-risk options when investing with high disposable income. Older investors with pressing concerns of retirement and health care costs may opt for low-risk investments with higher security.
It is always an option to use your greater capital in fixed-term investments. The longer you are away from retirement, the more you may gain from fixed-term investments rather than repaying your debt.
Younger investors also have greater opportunities to take higher risk investments because they have a greater capacity to recover from failed investments through income generation.
Interest on Debts
Some debts are not necessarily bad, such as mortgages and tax-deductible student loans. Simple interest concerns only the debt itself, whereas compound interest is more complicated. Compound interest concerns both the original debt and the interest accumulated during the length of the loan.
Paying Off Debt vs. Investing
When deciding whether to pay off your debt one should compare:
- The after-tax interest rate that you are paying on your debt
- The after-tax return you expect on your investment
If your investment returns are higher than the interest on your debt, then you should consider investing over debt repayments.
Can You Pay Off Your Debt and Invest?
When a person focuses all their money and attention on paying back high credit debt, it may be a slippery slope. Without a buffer of (they say 6 months or $1,000 at least), you will have no recourse but to run up more credit should any emergency arise.
That being said, you may opt to find a balance between savings, debt repayment, and investing which could make the process longer but provide you with long-term payoffs. This sadly is not a viable option for those of us with high-interest credit debt. Providing that your debt is low interest such as a mortgage may help you decide that investing is an option open to exploration.
High-interest debt can not only be a financial drain but an emotional burden. Once you have paid off your high-interest debts, you will have more money available to pursue your investments. This might necessitate cutting down on your discretionary 30% monthly spending, but it will improve your quality of life in the long term.
Always strive to have savings to buffer you from unforeseen circumstances that life throws and find yourself in situations where you may accrue credit card debt. Assess your financial baseline before jumping into any investments and make sure you have a solid financial footing before taking the plunge.
When deciding if you should pay off your debts or invest, remember that there is no guarantee on any investments. Many investments only yield their returns over longer lengths of time, with periods in between of negative growth. When considering investing it is always a smart idea to meet with the experts. Financial advisors can help guide you to the best investments suited to your individual financial needs.