5 Things to Consider when Deciding to Invest vs Pay Down Debt (Part 2)

 When we talk about deciding to invest or pay down debt, many people have many different opinions. While some people will give you a definite answer telling you to do one thing over another, many others will give you an honest but unsatisfying answer of “it depends.” In order to make the best decision for you, here are 5 things to consider:

1.     Volatility. Although the market may have had averaged returns of 8 to 10% over the past 30 years, this does not mean your money will increase by 8-10% each year. Some years the returns will go up and some years the value of your investments will go down. Be sure that you’re aware of this fluctuation so you can prepare for it. Investing involves risk. The more risk averse you are, the more it may make sense for you to pay down debt.

2.     Inflation. As we’ve all witnessed over the last couple years, most things increase in cost from year to year. Although the standard degree of inflation is about 2-4% per year, there can be years and times (such as the present) in which goods and services increase by nearly 10% in a year. The higher the percentage of inflation, the lesser amount you keep as “real profits.” The purpose of investing is to grow your money, but if inflation is high, then the true value of your money decreases and your profits are worth less. Make smart investments and don’t forget to factor in inflation when you are estimating your investment returns and comparing it to paying down debt.

3.     Risk. While it is normal for the value of your investment to fluctuate from year to year, one thing many people don’t always plan for is the risk that they could lose all of their money. Although scary, this is a possibility. Someone could steal your investment, the company you invested in could go bankrupt, the bank could confiscate it, and the value of the business could fall to zero. Some investments make those unfortunate scenarios more likely than others. Be sure that you are considering this if you decide to prioritize investing. Get a true sense for how risky the investment is, realizing that some investments are secured and insured while others are not. Spreading your investment across multiple companies or stocks or real estate helps to mitigate this risk. If you decide to invest, determine how much risk you are willing to take.

4.     Incentives. One of the things that can easily sway your decision one way or another when deciding to invest or pay down debt are monetary incentives. If your job gives you a match” to invest money for retirement, then investing makes sense because it helps you take advantage of that incentive. On the other hand, if your largest form of debt is your student loans and you are in some sort of loan forgiveness program that will pay down your debt for you, then taking advantage of that program and providing the minimum debt payment needed in the interim likely makes the most sense. Take a look to see if you are incentivized to do one over the other.  

5.     Taxes. Although it is nice to invest money and make profits, don’t forget to consider taxes. Those in high-income professions, who are often paying higher shares of state, federal, and FICA taxes must consider this even more. Are there ways you can invest that reduce your taxes? Are there incentives in the tax code that allow you to write off certain debt payments? Which types of investments or debt repayments lower your taxes the most?

Don’t forget to consider these 5 factors when deciding to invest or pay down debt

Should You Invest or Pay Down Debt?

When it comes to the age-old question of invest vs debt, many people wonder what to do. Some say invest without looking back. They tout that if the compound interest you can gain by investing is larger than the interest rate on your debt, then it's a "no-brainer." Other people say pay down debt. They mention that a life of no debt is a life of freedom and paying it down gives you a guaranteed return, free from risk. But is it really so black and white? How can two seemingly smart camps of people come to such vastly different conclusions?

When it comes to investing or paying down debt, the right answer depends on a unique set of circumstances and facts that can be ever changing in our lives. Yes, they include math. But they also vary based on our risk tolerance and individual values. Let's take a deep dive and examine this further.

Benefits of Investing

Investing has several benefits. For starters, it allows you to put your money in a position to grow and make a profit. Most people don’t build wealth or even acquire the funds needed to meet their financial goals by just saving. They are usually able to meet these goals investing, whether that’s in the stock market or in real estate or in some other lucrative business venture. The younger you are, the more likely investing will work out in your favor because you have more time for compound interest to turn your investing yield into even greater returns. Although nothing in life is guaranteed, and some investments can fluctuate in value from year-to-year, investing money allows your money to grow and can help you reach your financial goals sooner.

Benefits of paying down debt

Investing has benefits but so does paying down debt. For starters, paying down debt gives you a guaranteed return. Unlike investments that can decrease in value during market downturns, paying down provides certainty. It’s a surefire way to enhance your net worth. Not only does it decrease your liability, but it also helps to free up your cash flow. By getting rid of those monthly debt payments you will have fewer fixed expenses/bills and more money to spend on other things. In addition to more cash flow, paying down debt provides another benefit that can’t be quantified: financial freedom. There is no doubt that people, especially high-income earners, who are debt free, feel psychological freedom. They can leave jobs they don’t like without worrying about how they will repay their student loans. They can take guilt-free vacations and enjoy more of life's pleasures. People may lament certain investments that don’t pan out but very few people regret paying off debt.

So what should you do?

Should you aim for the growth and the magic of compound interest by investing? Or, should you free up your cash flow and get a guaranteed return by paying off debt?

It depends.

If you get a great investment return (like a retirement match at your job) then investing likely makes the most sense. If you have high-interest debt from a credit card or personal loan, then paying down that debt likely makes the most sense.

If you’re in between or neither scenario applies to you: Let the interest rate be your guide and if all else fails, split the difference.

If the interest rate on your debt is higher than the estimated, inflation-adjusted returns you expect from your investments then it likely makes more sense to invest. How do you make this comparison? Take the estimated return you expect to get from your investment, subtract out inflation, and compare your new inflation-adjusted return on investment to paying down debt. If the estimated return you get on your investment is still greater than what you would get on your debt then invest. If the estimated return you get on your investment is less than the interest rate on your debt then pay down the debt. If the returns are about the same or you are unsure which one is better, then do both. Use a portion of your income to pay down debt and another portion to invest. How much you allot to each category largely depends on your risk tolerance, personal goals, and overall financial plan. 50/50 is a good place to start.