Perhaps one of the biggest financial questions is what should I do with extra money? First off, if you do find yourself with extra cash on hand at the end of the month then pat yourself on the back because 78% of Americans live paycheck to paycheck and never achieve the sentiment of having left over money. Moreover, it is good that you are assessing what to do with the money rather than just blowing it on another materialistic item you definitely don’t need. What you may be asking yourself is how can I put this money to the best financial use therefore I want to answer the longstanding question of whether you should pay off debt or invest!
As I just mentioned, it is great that you have cash in hand to use to better your financial position. Whether that was from reducing your monthly expenses, negotiating a raise at work or supplementing your income with a side hustle, the more disposable income you gain access to, the more you will profit from the advice I am about to share with you.
Now, before we get into the financials on whether you should pay down debt first, I think it’s important to understand the psychology of this decision. For example, while it may make financial sense to put aside extra cash for investing, you may be more passionate about becoming debt-free and less motivated to save for retirement since it seems so far off. If that’s the case, you’ll be more willing to make sacrifices to pay back debt. On the other hand, if you’re excited about retiring early, it may be easier to live on a tight budget and invest for that goal than to live frugally to pay off a car loan early.
What I am trying to say is that it won’t simply be the more economical decision that you may go with in the end. As humans, we are at the mercy of our emotions and that almost always plays a role into how we spend our money. In fact, if you find that your emotions aren’t aligned to the decision that is the most financially fruitful then you have two options. Option one is to accept a lesser return but be aligned to your emotions or change your mindset and capitalize financially. There is no right answer in this case, it is merely a personal choice you will have to make for yourself.
There is one more caveat that needs to be addressed before we get into the answer of whether you should pay down debt or invest with your extra cash and it relates to the first option of debt repayment. I need to stress that you must make your minimum debt payments before allocating money toward any other goal, including the two options we are going to discuss.
Not making a required debt payment, or paying late, can be a financial catastrophe. You could damage your credit score, which would make borrowing in the future difficult or impossible. You could also incur substantial late fees and, in some cases, trigger penalty interest rates that substantially increase repayment costs. You could even face foreclosure or repossession if you don’t pay your bills. Therefore, before you do anything with your money, ensure your minimum balances are covered.
Option #1: Pay off debt
Alright, so let’s now dive into when it makes sense to pay down your debt first as this is one of the two options you are considering for that extra money you have on hand. When it comes to debt, the choice is often made for you. This is the case when you have high-interest debt that’s costing a fortune.
Dedicating extra money toward repaying high-interest consumer debts, like your credit cards, is likely to leave you financially better off than investing. Let me share with you an example to prove this point.
Let’s say you owe around $16,048 on a credit card at 15.59% interest — the average interest rate for cards in 2020 and the average credit card debt for households that carry a balance. If you made a median income of $57,617 and saved 20% of that income, you’d have around $960 per month to put toward financial goals.
If you paid the entire $960 per month toward your credit card debt, you’d be debt-free in 19 months and would pay a total of $2,162 in interest. But, if you paid only $300 monthly toward the credit card, it would take you 92 months — or 7.66 years — to become debt-free, and you’d pay $11,547 in interest.
With the first approach, you’d have to forego investing for 19 months but could redirect the entire $960 toward investments after that. Assuming a 7% return, you’d have around $85,500 saved in a 401(k) by the end of 7.6 years, even with investing nothing for the first 19 months.
With the second approach, you’d be able to invest the entire 7.6 years you were working on debt repayment, but would only be able to invest $660 per month because $300 would go toward your credit card. You’d end up with around $71,000 after 7.6 years. In this case, the interest on your debt is higher than returns you’re likely to earn by investing. In short, the higher the interest on your debts, the bigger the discrepancy between extra interest paid versus investment gains.
With high interest debts being a clear priority over investing, this doesn’t mean that every form of debt should be the first thing you put your money towards. As you probably guessed, lower-interest debts will not be as costly and will make for a less lucrative way to use this extra cash.
For example, if you have $100,000 worth of student debt that is charging you 3% then you will be required to make payments of roughly $1,000 if you aim to have it paid off in 10 years. Over the course of these 10 years, you will have paid almost $25,000 in interest for a grand total repayment of $125,000.
Option #2: Invest
However, if you were pay use that $1,000 a month instead and invest it into your 401(k) for the same 10-year timeframe at a 7% return, you would end up with $173,000, having earned more than $50,000 in interest. This $50,000 is double the interest you would be paying on your students loans which proves that it really depends what debts you are paying down when making this financial decision.
Now, those who are more advanced in their personal finance wisdom will make the argument that the benefit of paying down debt is that it is a guaranteed return whereas investing may not yield the return you are hoping for. Effectively, if you pay down debt, you are guaranteed a return at the cost of its interest whereas with investing the true return is never guaranteed.
However, this logic isn’t as clear cut as you would initially think. Here’s why. If you have a 30-year mortgage, the mortgage gets cheaper over time because $1 today is worth less tomorrow. Because interest savings doesn’t begin to accrue until years have passed, any interest savings needs to be discounted. From our student debt example, your $1,000 monthly payment would be unchanged for the 10-year time frame but it would only cost you $744 in today’s dollars. The $25,000 in interest savings would also start accruing after 10 years, so it would be worth less than $20,000 of today’s dollars, assuming a 3% inflation rate.
Since inflation makes the “guaranteed return” very small when paying off low-interest debt early, you could invest conservatively and still get a higher rate of return. This is especially true if you get a tax break for investing, or a 401(k) match from your employer, both of which effectively provide a “guaranteed return” equal to the value of the tax savings or matching money.
One final factor you must consider when it comes to the choice between paying down debt and investing is whether or not you can consolidate your loans. You see, you can reduce your interest rate of your high interest debts like your credit cards by using a credit card balance transfer. Often, you can get a low promotional interest rate, such as 0% financing. By moving your debt from a credit card with a high rate to the new card and have access to a prolonged period of time where the cost of that debt is significantly lower. This means that you can consider investing during that time frame since your returns will be greater than your interest fees and then assess your strategy when this time period ends.
Now, there is one more important element to consider when making this decision and it relates to everyone’s favorite financial topic: Tax! There will be tax implications associated with both investing and certain types of debt repayment, and you need to factor those into any calculations.
For example, if you invest in a 401(k) or IRA, you get tax breaks for investing. If you invest in a 401(k), the amount you invest will be deductible for tax purposes meaning that your current year tax bill will be lower which is always something you want to strive to attain. On the other hand, if you invest this extra money into a Roth IRA, the money is taxable now but the cash that goes into your portfolio will be accessible tax-free when you withdraw it which you will appreciate in your later years.
Now, whether you realize it or not there are also tax advantages on the debt side of the debate. If you have mortgage debt, you can deduct the interest paid on up to $750,000 in debt or up to $1 million in debt if your home was purchased before December 16, 2017.
Finally, if you have student loan debt, you can deduct up to $2,500 in student loan interest from your taxes. You don’t need to itemize to claim this deduction, but it does phase out for higher earners.
At this point, you may still be wondering what the best option is when it comes to paying down debt or investing and again it is a personal decision but let me tell you how I would approach this situation. Like I said earlier, you must pay your minimum balances, this is non-negotiable. Then, I would aim to pay down all my high-interest debt that is charging me more than the stock market historical return of 7%, that is assuming I couldn’t transfer it to a lower-interest debt instrument. Once I have that high-interest debt paid off, I would then start using my extra cash to invest on an ongoing basis while trying to increase my income. However, this is just my personal take and isn’t for everyone which is why I want to share with you one other option that may appeal to you.
Option #3: Split the difference
The third option is to divide up your extra money and do both. Dividing your efforts makes it harder to score wins and maintain momentum because you won’t get your debt paid off as fast, or hit investment milestones as quickly. Still, you can get around these motivation problems by taking steps such as automating debt payments and automating contributions to investment and savings accounts. If payments are automated, you won’t have to make the choice to do the right thing every month.
You can also use other techniques to cut spending, such as writing down your financial goals with clear deadlines for yourself, or paying only cash instead of relying on credit cards. The important thing is to find a way to stay motivated and make informed choices about how to use your extra money so you can end up with the highest net worth in the long run.