People who find themselves with extra cash can face a dilemma. Should they use the money 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 grow for the future? Either choice can make sense, depending on the circumstances.
- Investing and paying down debt are both good uses for any spare cash you might have.
- Investing makes sense if you can earn more on your investments than your debts are costing you in terms of interest.
- Paying off high-interest debt is likely to provide a better return on your money than almost any investment.
- If you decide to pay down debt, start with your debts with the highest interest rates and work down from there.
Investing vs. Debt Repayment: Key Differences
Investing is a way to set money aside for the future, ideally in an investment vehicle, such as stocks, bonds, or mutual funds, that will grow in value over time. Debt, on the other hand, represents money you've already spent and that a lender is charging you interest on. Left unpaid, that debt will grow and grow, with interest charges adding to your balance and incurring interest charges of their own.
The Case for Investing
As a general rule, if you can earn more interest on your money by investing it than your debts are costing you, it makes sense to invest. For example, if you have a mortgage with an interest rate of 5% and a stock market index fund that is returning 10% a year, you'll come out ahead by investing your extra cash in the index fund.
(On the other hand, if you have credit card debt at 20%, you'd be better off putting your extra cash toward paying that debt rather than investing it in the index fund.)
Unfortunately, it isn't always that straightforward. Investments can be volatile. That index fund might be up 10% this year but down 10% next year. While there are investments that pay a guaranteed interest rate, such as bank CDs and U.S. Treasury bills, they tend to have low rates of return that rarely exceed the interest rates that credit card companies and other lenders charge.
Another factor is more psychological. That's your risk tolerance. If you are comfortable taking the gamble that your investments will bob up and down with the markets, sometimes rising in value and sometimes losing value, you are a better candidate for investing than someone who would lie awake nights worrying about what the market might do tomorrow.
The Case for Paying Down Debt
There are several good arguments for choosing to pay down debt rather than investing. The first, as mentioned above, is that you might come out ahead if your debt carries a relatively high interest rate. That's especially true with credit card debt. The average interest rate on credit cards tracked in Investopedia's credit card database was recently 19.62%. There are few investments that can match that rate of return.
Another solid reason to pay down debt involves your credit score—a number that can be very important if you want to borrow money in the future, such as for a mortgage or a car loan. Having a low credit score can mean paying higher interest rates, if you can get a loan at all. Your credit score can even affect other aspects of your life, such as the premiums you'll pay for insurance, whether a landlord will rent to you, and whether an employer will hire you.
Credit scores are based on a number of factors. In the case of the most widely used one, the FICO score, your credit utilization ratio—the amount of credit you are currently using compared to how much credit you have available to you—accounts for a significant portion of your score. So, for example, someone whose credit cards are all maxed out is likely to have a considerably lower score than someone whose credit cards have been paid off or at least paid down to a more reasonable level.
Paying off debt, particularly if you have a lot of it, can be a smart move for that reason alone.
As with investing, psychology comes into play here, too. If you're losing sleep over your debts, you could be better off repaying them—even if you might get a better return on your money by investing.
The Case for Doing Both
Paying down debt vs. investing doesn't have to be an either/or decision. You can, and sometimes should, do both. For example, if you don't already have an emergency fund you might want to use some of your money to create one, while using the rest to pay down your debts. A good place to keep your emergency fund is a low-risk and highly liquid (that is, easily and quickly accessible) investment, such as a money market mutual fund.
How to Pay off Debts
If you've decided to use your spare cash to pay off your debts, the next question is how to go about it. If you have enough money to cover everything you owe, the answer is pretty simple: just pay it off. However, if you don't have that much cash to spare, you will need to prioritize.
Generally speaking, you'll get out of debt faster if you start by paying off your debt with the highest interest rate first and working your way down from there. For example, if you have balances on two credit cards, one that's charging you 20% and the other charging 15%, tackle the 20% one first.
In the case of credit card debt you may also have another option: transfer your balances to a card with a lower interest rate and then pay them off. Some balance transfer credit cards offer promotional periods of six to 18 months, when they charge 0% interest, which can help you pay your balance down faster since you won't be incurring additional interest. Investopedia publishes regularly updated ratings of the best balance transfer credit cards.
Still another option is a debt consolidation loan from a bank or other lender. The way that works is, you borrow enough money from the lender to pay off your other debts. Now you just have one debt to worry about, ideally with a lower interest rate than your prior debts. You can then use your extra money to begin paying that loan off. Investopedia also publishes ratings of the best debt consolidation loans.
If You're Really Deep in Debt
If your spare cash won't begin to make a dent in your debt, you may need to consider some more drastic measures. First, if you're having trouble making even the minimum monthly payments on your credit cards or other loans, contact your lender. It may be willing reduce your minimum payment or the interest rate on your debt.
Another option is hiring a reputable debt relief company to handle negotiations for you. This is an area that's rife with scams, so make sure you know who you're dealing with. As the Federal Trade Commission notes, "These operations often charge cash-strapped consumers a large up-front fee, but then fail to help them settle or lower their debts—if they provide any service at all." Investopedia publishes annual ratings of the best debt relief companies.
The Bottom Line
Having some extra cash is an enviable situation to be in. Whether to invest that money or use it to pay down your debts is a question only you can decide. But either use is better than simply spending it. Whichever course you take you decide to take, you'll be in a better financial situation than you were before.