What to Do with your Extra Cash? Invest or Pay Down Debt?
If you are asking yourself the question what should I do with my extra cash? then congratulations, as you already made some good choices! First, because you were able to save extra money, and second, because you decided not to spend it right away!
Whether to invest or reduce debt is a common question, and there are different approaches to consider. We are going to go over various aspects that characterize the 2 options, and see different situations that could influence your decision.
The return on investment
The first question you should ask yourself is, how much will I gain from investing or paying down my existing debt?
An individual that is not in a situation forcing him to make a specific choice, should evidently go with the option giving him the highest return. Even debt has a return on investment; eliminating monthly interest costs of $250.00 is worth as much, in your personal budget, as an investment giving you a return of $250.00 a month.
Another way to understand this comparison is to imagine an individual getting a new loan with the objective of investing the amount borrowed. Here, the investor seeks to get a higher return with his investment than what the borrowed amount would cost him in interest and fees.
It is the same principle when you plan to invest extra cash, while carrying loans. By investing the cash surplus, instead of paying down the debt, you pass on the opportunity of reducing your debt balance, and therefore you will be paying interest on the portion that could have been paid off. However, the goal is for the invested amount to give a higher return than the interest you would have saved.
To measure the cost and return, we need to compare the effective rate of return of both options, the debt's interest and investment's return. Eliminating a loan with an effective interest rate of 5% is the equivalent of investing the same amount at an effective rate of return of 5%. The same way, you would stay neutral if you invest a borrowed amount at 5% interest and get a 5% rate of return of the amount invested. The investor should therefore orient his actions on the highest rate of return. But there are other aspects to consider.
One variable that can influence the return are the taxes applied on the investment income. An investor doesn't have to pay taxes when eliminating the interest and fees of his debt, by paying it off. However, he has to pay taxes on the income he receives through interest income and dividends. As an example, a return on investment of 8% will actually give you a return of 5% or 6% net of taxes, depending on your tax bracket. However, if you pay off a debt at 8%, this will make you save 8% in interest costs. Therefore, in order to get the equivalent net rate return between clearing off a debt or cashing on investment income, you would need to invest at a rate of close to 8%, in order to equal the elimination of a debt at 5% or 6% interest rate.
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. Sometimes, an entire amount invested in a retiring plan, for example, can be deducted from the taxable income and consequently reduce the amount of taxes due. Other investment plans, such as tax-free savings accounts, can free you from paying taxes on your interest income. Therefore, the gross rate of return will not be taxable.
Risk is of course part of the equation. The rate of return on an investment is never really guaranteed, and there's even a risk of loss. It can fluctuate unless you invest in securities that give a guaranteed return, but when it is a guaranteed investment the return is never high. Paying a debt, however, will bring you a guaranteed return. If you pay off a loan at an interest cost of 4%, then you eliminate the entire rate of 4%.
If you plan to pay off your debt, paying off your credit cards should be the priority since they have extremely high interest rates, usually around 20%. An investor that tries to get a rate of return of 20% in the financial markets will require great risk, and potentially great losses. But if you plan to hold on to your investments with the goal of growing them passively, like with mutual funds, then you will never get a rate of return as high as credit cards, but the risk of loss is much lower.
Before investing, you should always make sure you don't have any credit issues, because investing when you are crumbling under debt and late payments is a bad idea, and it will definitely not help you improve your credit score. When your credit score is low, loans will be provided at a higher rate because you represent a higher risk of default, unless you can provide assets as a guarantee. Therefore, investing might not be a good idea if you have a precarious budget, and can't even make the minimum payments on your debt. You will end up paying higher interest rates and possibly late fees.
When planning financially for retirement, it is important to start investing at a young age, or else you risk not getting a guaranteed income in the future when you stop working. Unfortunately, eliminating debt alone won't guarantee you an income from which to live from. Ending your career with no debt, but no savings either, will not give you the possibility to stop working. It is recommended to start saving and investing small amounts at a young age, 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 investments for retirement is not optimal.
Reimbursing loans should be done in a particular order. Some recommend paying the loan with the highest interest rate first, also known as debt avalanche, while others suggest paying the lowest balance first, called debt snowball. When you pay off the loan with the highest interest first, you are getting rid of the interest portion faster, and start paying off the capital portion earlier.
If you start paying off the loan with the lowest balance, you will then free your monthly payments faster (by eliminating the loan) and end up having a cash surplus which you can then use to pay other debt. This technique gives you a tremendous sense of accomplishment because you see debt and monthly payments disappear. It also frees up extra cash more rapidly, which can be a priority in some cases.
In general, you should always aim to pay the least interest possible by paying off the loan that has the highest interest rate first.
It is also important to make your debt payments as soon as possible, and avoid paying unnecessary interests and fees. Keep in mind that eliminating revolving credit won't stop you from using the credit again if needed, but in the meantime, the balance and interest cost of the loan will have become smaller, ultimately fulfilling the objective of lowering the interest cost to the maximum.
Choosing between investing or reducing your 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, the need for additional cash, or the lack of investments when preparing for retirement, will greatly influence your decision. Keep in mind you can always divide the cash surplus to pay your debt and invest at the same time. Finally, it is always good to consult a professional who can evaluate your situation and give you the appropriate advice, but you need to understand the reality of your personal financial situation as you are the one taking the final decision.