To Invest or To Pay Off Debt, the question of the ages. You might think that the answer it’s pretty obvious, but on the contrary, you need to dig a little deeper. Like any other financial question, it really all depends on your own financial picture.
Here is the simple answer. If your investments earn more than the interest you’re paying on your debt, then it would make sense to invest. However, if you have high-interest debt such as credit cards, then it probably makes more sense to pay off your debt first.
It’s a little more complicated than that though. Let’s talk more about it and figure out if you should invest or pay off your debt.
Is it good debt, or bad debt?
First things first. It’s important to determine if your debt is good debt or bad debt. Good debt is debt that makes you more money. For example, having a mortgage on a rental property is good debt. Having a car payment for a car that you exclusively use on Turo is good debt. It only counts if you’re making a profit off of it greater than the interest being charged.
On the other hand, bad debt is debt that does not make you any money. Personal loans, car loans, credit card debt, payday loans, are all forms of bad debt. This type of debt severely slows down your path to Financial Freedom. If you have bad debts, it’s probably a good idea to pay those off completely before doing any investing. You might be tempted to just ignore the bad debt, but getting yourself into more debt even if it’s good debt is not a good idea. You’re just digging yourself into a deeper hole. In this case, you would rather pay off debt than invest.
What about a mortgage?
All right, how about if you have a mortgage. Since 2012, mortgage rates have been at historic lows. And the time of writing this, mortgage rates are averaging 3 to 4% on a 30-year mortgage. This is really cheap money, and makes no sense paying that off first.
If all you have left is Mortgage Debt and you don’t have bad debt like credit cards, then you’re better off investing your money and making it better return. Instead of paying ahead on your mortgage, use that money and invested in index funds and the stock market. You can expect an average of 5 to 10% a year in returns. Much better to invest than to pay off the mortgage debt in this case.
Student loans typically have pretty low-interest rates. This might mean that you can potentially make a high return investing than paying off your student loans first. There is a big caveat to that too though.
Although student loans might have a lower interest rate than credit cards, this is also considered bad debt. Student loans don’t make you money. They also typically have a pretty high monthly payment, and you’re stuck with them forever. Because of this, it might make a lot more sense to pay off your student loans first. This will free up a lot of cash flow once they are paid off. Definitely pay off the debt before you invest.
Calculate your DTI ratio
Your debt to income ratio is an excellent indicator of how much debt you’re carrying compared to your income. Figuring out your debt to income ratio is a pretty simple formula. You simply divide all your monthly debt obligation by your monthly gross income.
Once you figure out your debt to income ratio, then you’ll have a clear picture of how deep in debt you’re swimming. If all you have is good debt, but your debt-to-income ratio is above 23%, then you should probably consider paying off your debt first!
Can you pay off debt and invest at the same time?
Yes, and it’s probably a better idea to do both! How you may ask? By investing in a company-provided 401k!
No matter what your strategy is, investing for your retirement is Paramount! If you are employer offers a 401k, always make sure that you contribute to it without fail. If they offer a company match, then make sure you contribute enough to meet that match! It’s free money, and it’s your retirement fund, So do whatever it takes to contribute to it. Always!
When deciding whether to invest or pay off debt, no matter what your financial picture looks like, or what’s your strategy might be, it is almost always universally more important to pay off debt first. Every time.
Sure, you might have some strategies of you sleeves, but always try to pay off your debts first. The only exception to this would be any mortgage as you’re almost guaranteed to you make more interesting elsewhere. Food for thought.
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