A common situation that people usually face is deciding between paying down debt or investing. Both are necessary to have a financially sound life. Paying off your debt reduces your stress and increases your ability to withstand personal emergencies while investing allows you to build a reserve that can protect you and your family and provide you with sources of passive income.
Know your debts
High interest is relative, but anything above 10% can be considered as high-interest debt. Carrying any kind of balance on your credit card or similar high-interest vehicle makes paying it down a priority before starting to invest.
Low-interest debts may often be a car loan, home loans (depending), a line of credit or a personal loan from a bank. Even though the interest rates on these types of loan might be lower, there is still some pressure that comes from investing with these types of debts.
Ideally, the most intelligent course of action when deciding between paying off your debt and investing should be to compare two variables – the rate of interest you are paying on your debt and the rate of return you expect to earn on your investments. Basically, if you can earn a higher return on your investments than the interest on your debt, you should invest. Otherwise, pay off your loans first.
Prioritising is key; you need to know the types of funds to build and types of debts to pay off.
1. Build an emergency fund
An emergency fund is highly important to build in case of any unexpected events that occur such as sudden unemployment, disability, illness etc. Since it acts as a buffer, it provides a financial and emotional security. Ideally, you should have at least 6 months of expenses set aside as an emergency fund.
2. Pay off high-interest loans
There are several factors involved in this but as a rule of thumb: if you’re unable to gain investment returns more than the interest rates on your loans, you’d be better off paying down your debt instead.
3. Contribute to any retirement account
“It might be too late to wait till you’re completely debt-free (which may or may not even happen) and you will lose out on compounding interest if you start saving or investing later. Starting small is better than starting later.” – Jason Tan
Retirement planning should be one of the top priorities in your list. It is always better to start early to take advantage of compounding effect of most retirement accounts.
4. Begin building assets
Similar to contributing to a retirement account, building assets early allows you take full advantage of compounding interest. However, you should only make riskier investments when your other basic needs are met. For example, if you have a lot of debt and an emergency fund worth only 2 months of your expenses, you probably should not be investing in risky stocks.
The bottom line is that you are the variable that matters. You can always invest in spite of debt, but the question is whether you should or not. The answer largely relies on your own financial situation and risk tolerance. There are benefits in getting your money into the market as soon as possible but there is also no guarantee that your portfolio will perform as expected.
The biggest benefit of investing while in debt is psychological. Paying down long-term debts can be tedious and disheartening as for many people, it seems like they are struggling to get to the point where their normal financial life – that of saving, investing, etc. can begin. Having a modest portfolio to track while in debt can make you feel good about growing your personal finances.
Financial Services Manager
CFP®, ChFC®, AEPP®