Should you Invest or Pay down Debt with your Excess Cash?
If you ask yourself the question what should I do with my extra cash, reduce debt or invest?, you already made some good choices. First, because you were able to save some extra cash, and second because you decided not to spend it. Investing or reducing debt is a common question, and there is an approach to consider. We are going to go over the different aspects that characterize both options and go through situations that could influence your decision.
The first question you should ask yourself is, how much will I gain from investing or paying down debt? An individual that is not in a particular situation that forces him to make a specific choice should go with the option giving him the highest return. Even debt have a return on investment, after all eliminating a loan with monthly payments of $250.00 is worth as much, in your personal budget, as an investment giving you $250.00 a month.
Another way to understand this comparison is to imagine an individual opening a loan with the objective of investing the amount. The borrower investor seeks to make a higher return with his investment than the cost of the new loan, obviously. It is the same principle when you are planning to invest cash excess while carrying loans. By investing the cash surplus, you pass on the opportunity of reducing your debt balance, and therefore you will pay interest on the portion that could have been paid down. This debt portion is just like a new loan, and you are looking to invest it at a higher return than what it will cost you.
To measure the cost and return, we need to compare the effective rate of both options, which is the debt's interest and investment's return. Eliminating a loan with an effective interest rate of 5% is the equivalent of investing a same amount at an effective return of 5%. Also, you stay neutral by investing at 5% an amount you borrowed at a rate of 5%. So financially, an individual wins by orienting his action on the highest rate. But it doesn't stop at the gross rate alone.
One variable that can influence the return is the taxes on investment income. We don't pay taxes on a net revenue increase due to debt reduction, but certainly on a gross income increase because of new investment income. A return on investment of 8% will give you a net return of 5% or 6% depending on your tax bracket rate, where the elimination of a loan covers the entire rate. In our example, to get the equivalent net rate between a debt and an investment, a person would need to invest at a rate of close to 8% to get the equivalent of eliminating a 5% or 6% debt.
But there are ways to reduce the impact of taxes. Some people are able to deduct from the taxable income the interest paid on a loan, and sometimes an entire amount invested in a retiring plan, and consequently reduces taxes. Other investment plans such as a tax-free savings account will free you from paying any taxes on the interest income, so in that case the whole investment rate of return is to be considered since it is not taxable. Bottom line, the applicable taxes can change the net return.
The risk is also part of the equation, since the rate of return on investment is never really guaranteed, it can fluctuate, unless you invest in securities giving a guaranty return, which in that case is never really high. The rate of return for an investment can be more, or less, what was expected, and there's even a risk of losses. Paying a debt for its part will bring you a guaranteed return. Indeed, paying a loan at an interest of 4% will, without any doubt, eliminate the entire rate of 4%.
In general, credit cards should be the first targets, because they have an extremely high interest rate, around 20%. The credit card rate is very rare to get on the financial markets, unless you take great risks, which at the same time can bring great loss. Entrepreneurs could hope of getting a rate as high as 30% in their business since they know what they're investing in, but this requires time and effort. However, if you are thinking about just letting passively your investment grow, like with mutual funds, you will never get a rate as high as credit cards.
Before investing, an individual should make sure not to have any credit issues, because investing when you are crumbling under debt and late payments will do nothing to improve your credit score. We have to be aware that, when your credit score is low, loans will be provided at a higher rate, because you represent a higher risk of default, unless you lend guarantees. So investing doesn't seem to be the right thing to do if you have a precarious budget and can't even make the minimum payments on your debts. You will also end up paying higher interest rate, in total, and possibly late fees.
On the other side, there is the danger of not having any investments when you are close to retirement. Being aggressive on eliminating debts will never guarantee you an income for your retirement. Ending up your career with no debt but no saving won't give you the opportunity to stop working. It is actually recommended to start saving and investing small amounts when you are young, because starting to do so at an old age will require heavy money saving efforts. Even if eliminating debt is a great objective, doing it at the cost of having zero investment for retirement is not optimal.
Reimbursing loans, if this is the option chosen, should be done in a particular order. Some recommend paying the loan with the highest interest rate first, also known as debt avalanche, and others suggest paying the lowest balance first, also called debt snowball. When you pay the loan with the highest interest first, you will always pay the least interest possible on your loans, because you get rid of the interest portion faster and start paying the capital portion earlier. Starting with the lowest balance, however, will free monthly payments faster, because you eliminate the easiest loan to get rid of first, and then have a greater cash surplus to pay other debts. This technique gives you a tremendous sense of accomplishment because you see debt and monthly payments disappearing quickly. It also frees up extra cash flow more rapidly, which can be a priority in some cases. But in general, you should always pay the least interest possible by starting with the loan with the highest interest first.
It is important also to make the payments on your debt as soon as possible, and avoid paying unnecessary interest while wondering. At worst, eliminating revolving credit won't stop you from using it again if needed, but the balance on which the interest is normally applied during that time would be smaller, or even gone; the objective is to lower the interest cost to the maximum.
Choosing between investing and reducing debt balance
We realize that a mathematical calculation to choose the best option is probably necessary, but not sufficient. Your personal situation, such as struggling with your credit score, a need for additional cash or the lack of investments when preparing your retirement, can greatly influence your decisions. In fact, the option to pay debt and invest at the same time is always available by dividing the cash surplus. Finally, it is always good to consult a professional who can evaluate your situation and give you appropriate advice, but you also need to understand correctly your financial situation, because you are the one making the final decision.