Paying off Debt vs. Investing Further: An Overview
People who find themselves with extra cash often face a dilemma. Should they use the windfall to pay off—or at least, substantially pay down—that pile of debt they've accumulated, or it is more advantageous to put the money to work in investments that will build a nest egg? Both options are important.
Investing is the act of setting aside money that will, itself, earn a profit and grow. Investing is not the same thing as is pure savings, where the money is set aside for future use. When you invest, you expect the money to return some income and increase the original amount. Investing provides the peace of mind that you will have funds available to endure a future financial milestone. Retirement, business projects, and paying for the college education of a child are examples of such financial milestones.
Debt refers to the action of borrowing funds from another party. Some of the most common debts include borrowing to purchase a large item such as a car or a home. Paying for education or unplanned medical expenses are also common debts. However, a debt many people struggle with every month is credit card debt. According to research from the Federal Reserve Bank of New York, credit card debt ended 2018 at a record of US$870 billion. How to go about paying off debt is a problem many people worry about every day—it is also a problem many lose sleep over every night.
Investing is the act of using money—capital—to make returns in the form of interest, dividends, or through the appreciation of the investment product. Investing provides long-term benefits and earning an income is the core of this endeavor. Investors can begin with as little as $100, and accounts can even be set up for minors.
Perhaps the best place for any new investor to begin is talking to their banker, tax account, or an investment advisor who can help them to understand their options better.
Types of Investments
There are many products that you can invest in—known as investment securities. The most common investments are in stocks, bonds, mutual funds, certificates of deposit (CDs), and exchange-traded funds. Each investment product carries a level of risk and this danger connects directly back to the level of income that a particular product provides.
CDs and U.S. Treasury debt are considered the safest form of investing. These investments—known as fixed-income investments—provide steady income at a rate slightly higher than typical savings account from your bank. Protection comes from the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the strength of the U.S. government.
Stocks, corporate bonds, and municipal debt will move the investor up on both the risk and return scale. Stocks include large-cap, blue-chip companies such as Apple (AAPL), Bank of America (BAC), and Verizon (VZ). Many of these large, well-established firms pay a regular return on the invested dollar in the form of dividends. Stocks can also include small and startup companies that seldom return income but can return a profit in the appreciation of share value.
Corporate debt—in the form of fixed-income bonds—helps businesses grow and provide funds for large projects. A business will issue bonds with a set interest rate and maturity date that investors buy as they become the lender. The company will return periodic interest payments to the investor and return the invested principal when the bond matures. Each bond will have credit rating issues by rating agencies. The most secure rating is AAA, and any bond rated below BBB is considered a junk bond and is much riskier.
Municipal bonds are debt issued by communities throughout the United States. These bonds help build infrastructures such as sewer projects, libraries, and airports. Once again, municipal bonds have a credit rating based on the financial stability of the issuer.
Mutual funds and ETFs are baskets of underlying securities that investors can buy shares or portions of. These funds are available in a full spectrum of return and risk profiles.
Determining Your Risk Tolerance
Your risk tolerance is your ability and willingness to weather downturns in your investment choices. This threshold will help you determine how risky an investment you should undertake. It cannot be predicted exactly, of course, but you can get a rough sense of your tolerance for risk.
Factors influencing your tolerance include the investor's age, income, time horizon until retirement or other milestones, and your individual tax situation. For example, many young investors can make back any money they may lose and have a high disposable income for their lifestyle. They may be able to invest more aggressively. If you are older, nearing or in retirement, or have pressing concerns, such as high health care costs, you may opt to be more conservative—less risky—in your investment choices.
Rather than investing excess cash in equities or other higher-risk assets, however, you may choose to keep greater allocations in cash and fixed-income investments. The longer the time horizon you have until you stop working, the greater potential payoff you could enjoy by investing rather than reducing debt, because equities historically return 10% or more, pretax, over time.
Pay Off Debts
Debt is one of those life events that most people experience. Few of us can buy a car or a home without taking on debt. Sometimes unforeseen events happen like medical expenses or the expense you may have after a hurricane or other natural disaster. In these times you may find you don't have enough readily available funds and need to borrow money.
Besides loans for large purchases or unforeseen emergencies, one of the most common debts is credit card debt. Credit cards are handy because there is no need to carry cash. However, many people can quickly get in over their heads if they do not realize how much money they spend on the card each month.
However, not all debt is created equally. Keep in mind that some debt, such as your mortgage, is not bad. The interest charged on a mortgage and student loans is tax-deductible. You will have to pay this amount, but the tax advantage does mitigate some of the hardship.
Interest on Debts
When you borrow money, the lender will charge a fee—called interest—on the money loaned. The interest rate varies by lenders, so, it is a good idea to shop around before you decide on where you borrow money. Also, your credit rating will affect how good of an interest rate you receive on a loan.
Your lender may use compound or simple interest to calculate the interest due on your loan. Simple interest has a basis on only the principal amount borrowed. Compound interest included both the borrowed sum plus interest charges accumulated over the life of the loan. Also, there will be a date by which the funds must be paid back to the lender—known as the repayment date.
The interest charged on loans will usually be higher than the returns most individuals can earn on investment—even if they choose high-risk investments. When paying down debt, there are many schools of thought on what to pay first and how to go about paying it off. Again, a banker, account, or financial advisor can help determine the best approach for your situation.
Building a Cash Cushion
Financial advisors suggest that working individuals have at least six months' worth of monthly expenses in cash or a checking account. This safety cushion should be the first priority, but if your debt is too high, it may be impossible for you to accumulate that much money.
Advisors recommend that individuals keep a monthly debt-to-income ratio (DTI) of no more than 25% to 33% of their pretax income. This ratio means that you should spend no more than 25% to 33% of your income in paying off your debt.
Paying off debt takes planning and determination. A good first step is to take a serious look at your monthly spending. Look at any expenses you can reasonably cut back on such as eating lunch out instead of brown-bagging a lunch. Determine how much you can save each month and use this money—even if it is only a few dollars—to pay off your debt. Paying down debt saves funds going toward paying interest that can then go to other uses.
Create a budget and plan how much you will need for living expenses, transportation, and food each month. Do your best to stick to your budget. Avoid the temptation to fall back into bad spending habits. Dedicate yourself to sticking to your budget for at least six months.
Methods to Pay Off Debt
Some advisors suggest paying off the debt with the highest interest first. Still, other advisors suggest paying off the smallest debt first. Whichever course you take, do your best to stick to it until the loan is paid.
Several different budgeting methods allow for both debt repayment and investments. For instance, the 50/30/20 budget sets aside 20% of your income for savings and any debt payments above the minimum. This plan also allocates 50% to essential costs—housing, food, utilities—and the other 30% for personal expenses.
Financial advice author and radio host Dave Ramsey offers many approaches to budgeting, saving, and investing. In one, he suggests saving $1,000 in an emergency fund before working on getting out of debt—paying off debt other than your home mortgage—as quickly as possible. Once all debt is eliminated, he advises returning to building an emergency fund that contains enough money to cover at least three to six months of expenses. Next, his plan calls for investing 15% of all household income into Roth IRAs and pre-tax retirement plans while also saving for your child's college education, if applicable.
Special Considerations - Taxes
The type of debt or type of investment income can play a different role when it comes time to pay taxes. Whether you pay off debt or use the money to invest, is a decision you should make from a number's perspective. Base your decision on an after-tax cost of borrowing versus an after-tax return on investing.
As an example, assume you are a wage earner in the 35% tax bracket and have a conventional 30-year mortgage with a 6% interest rate. Because you can deduct mortgage interest—within limits—from your federal taxes, your true after-tax cost of debt may be closer to 4%.
Student loans are a tax-deductible debt that can save you money at tax time. The IRS allows you to deduct the lesser of $2,500 or the amount you paid in interest on a qualified student loan used for higher education expenses. However, this deduction phases out at higher income levels.
Income earned from investments is taxable. This tax treatment includes:
- Income from interest paid from bonds, CDs and savings accounts
- Dividends paid from stocks—also called equities
- The profit you make when you sell a holding that appreciated—known as a capital gain
- Investing is the act of using your money to make money.
- Investment income comes in the form of interest, dividends, and asset appreciation.
- Investment income comes in the form of interest, dividends, and asset appreciation.
- Debt is the borrowing of money to finance a large or unexpected event.
- Lenders charge either simple or compound interest on the loaned sums.
- Building a cash cushion, creating a budget, and applying a determined method will help to pay off debt.