Many people with debts often ask themselves; should I invest or pay off debt first. If you are asking yourself this question, you are not alone. Some of the common debts include credit card debts that have high-interest rates. To achieve financial freedom, you need to be free from debts and yet you also need to invest. But which one should come first. In this article, we will help you answer this question; should I invest or pay off debt first? Let’s dive into it right away.
Pay Off Debt vs Investing
Investing is a way to grow your money. Investments are vehicles that enable you to grow wealth over time and have regular returns. Investments include stocks, mutual funds, and bonds. Paying off debt on the other hand is money you had borrowed and used and you need to pay it off with an interest rate. If a debt is left unpaid, it can accumulate and can make you be declared bankrupt or you can fall in a debt trap.
Should I Invest or Pay Off Debt?
Whether to invest or pay off debt first depends on individual case scenario. For instance, if the rate of return on investment is higher than the interest rate of your debt, then it makes more sense to invest first. For instance, if you have a personal loan with an interest rate of 7% and have an investment with a return rate of 12%, it is best that you first invest.
Investing while Paying Off Debt
Investing while paying off debt is the best-case scenario. If the interest rate of your debt is lower than the return rate of your investment, then consider investing while paying off your debt. However, you need to have enough money to cover both investments and paying off debt. If you don’t have enough money, then you can start by investing.
If you are investing and paying off debt, you need to have an emergency fund. An emergency fund helps you cater to urgent and unforeseen needs. You need to keep your emergency fund in a low-risk and highly liquid investment. A good example of such an investment is the money market fund. Here, you can easily access the funds and cater to your needs.
Should I Pay Off Student Loans or Invest?
Whether to pay off student loans or invest depends on the student loan interest rates versus the rate of return on investment. Normally, student loans under the federal program have interest rates of between 2.5% and 5.5%. Private student loans have interest rates of between 8% and 13%. Interest rates on both federal and private student loans have a fixed rate.
Therefore, if the rate of return on investment is higher than the interest rate of your student loan, consider investing first. You can then use the returns on investment to pay off your student loan. If it is the other way round, consider paying off your student loan first.
Should I Use Stocks to Pay Off Debt?
It is not a good idea to sell your investments like stocks, bonds, and mutual funds to pay off debts. Investments help you build your financial security and selling them off to pay off your debts leaves you vulnerable to more debts.
Although investments have their risks such as inflation, you can hedge them against such risks. Besides, debt is a short term and it shouldn’t be a barrier to financial security, which is a long-term goal.
Read more: How to hedge against inflation.
Should I Use Retirement Funds 401(k) to Pay Off Debt?
Using your 401(k) to repay your debt is a bad idea. A 401(k) is a long-term goal and you shouldn’t use it to pay off a short-term goal. Besides, withdrawing money from your 401(k) attracts penalties and is subject to high tax charges. The result is that you are left with less money for your retirement.
However, you can borrow from your 401(k) to pay a credit card debt, but your employer needs to authorize it. But, you must pay it back in case you want to leave your job.
How to Pay Off Debt
The means to pay off your debt depends on how deep you are into debt and the interest rates. Generally, this is how you can easily pay off your debts.
1. Debt Consolidation
If you are into deep debt, consider debt consolidation. Debt consolidation is taking a new loan that has a lower interest rate to pay off credit card debts. Credit card debts are risky due to their high-interest rates. You can use collateral to lower the interest rate of your loan. If the debt consolidation rate has a low-interest rate compared to the average rate of return on investment, consider investing first.
2. Come Up with a Budget
The other thing you need to pay off your debt is to come up with a budget. A budget helps you track your expenses, pay off your debts and set aside savings. Sticking to your budget can help you pay off your debt faster. A budget helps you become more frugal on your spending and ensures that every coin is used where it is supposed to be spent.
3. Save an Emergency Fund
You need to set aside an emergency fund to cater for unexpected expenses like medical bills or job loss. Life curveballs like the loss of a job require you to have some cash that can support you before you can find an alternative source of income.
Summary of Whether to Invest or Pay Off Debt
Whether to invest or pay off debt depends on the rate of return on investment versus the interest rate of the loan. If the rate of interest of the loan is higher than the rate of return on investment, consider paying off the loan first. Otherwise, you can start by investing. However, before investing, consider risks associated with investing such as inflation.