Last updated in December 2020
It is not easy to figure out whether you should pay off debt or invest your money instead. On one hand, you could finally be debt free. But on the other hand, you could take advantage of low stock prices or compound interest.
How can you find out which decision is right for you? There are few factors to take into account but oftentimes, the answer may be more obvious than you think.
Monethalia does not offer financial advice. Should you take any action based on the information provided, Monethalia will not be liable for the outcome.
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Should you pay off debt or invest your money?
A lot of people have both savings and debts and do not even seem to be bothered by this fact. Unaware that they are losing money by the day, they live their lives in blissful ignorance. This is not what effective money management should look like, and it may be time for these people to rethink their finances.
First of all, before you consider whether you should pay off debt or invest, you should build an emergency fund. This will protect you if anything goes wrong. If your debt has a high interest, you may want to start with a small emergency fund and build it up over time.
Subsequently, you can consider a number of other factors that will help you to make a decision:
- Interest vs. fund growth
- Psychological factors
Interest versus fund growth
The most decisive factor of whether you should pay off debt or invest is the interest rate. There are two numbers you need to take into account:
- The interest you pay on your debt
- The interest you make from your potential investment
If the interest on your debt is higher than the amount you can expect to make from investing money, you should prioritise repaying your debt. This will almost always be the case unless you have a very low-interest debt.
If you invest in index funds, you can assume an interest of 7% on average. Please note that in some years your fund will grow more but you should nonetheless use 7%. Savings accounts traditionally pay very low interest rates and as such, it is almost always more effective to pay off your debt.
You may be lucky to pay a very low interest rate on your debt, for example, mortgages or interest-free loans. In these cases, it makes sense to invest from a purely financial perspective.
Pay off debt or invest: Security
However, interest rates alone are not the only factor to consider. One important point is that investments can go up and down over time. Even index factors can have a long-term decline in value during prolonged economic recessions.
During economic downturns, you still need to make your debt repayments. Should you need to access your investments during one of these times, you are bound to be left with a loss. This loss may be large enough to nullify any gains from investing over paying off debt, leaving you down overall.
Therefore, investing over paying off your debt does not come without risk. A well-funded emergency fund and other cash savings are the most effective way to manage this risk. However, here you have to keep in mind that cash savings generally earn low interest which means it would be financially more effective to pay off your debt first.
Access to money is a related issue to security. You cannot access any money that has been used to repay debts. However, investments can be accessed at any time (unless you invest in property, etc.), even if you end up with a loss.
In an emergency, you could potentially ask your lender to reduce your monthly repayment rate. This would mean you are paying off your loan over a longer period of time. Thus, you also pay more total interest. But at least you have money to feed yourself and keep a roof over your head.
However, if you had paid off your loan, you could simply take out another to cover your emergency. There is no right or wrong way to look at it. Whether you prefer to pay off debt or invest is a matter of personal preference in regards to accessibility.
Security and accessibility can be seen as an advantage or disadvantage depending on your personal situation. It is therefore important to consider both points carefully.
People often prefer to be safe and the mental burden that comes with having debt can be damaging. In fact, this damage can impact your daily life and go as far as turning into depression. Therefore, if you find your mental health to be affected, it is always better to pay off debt than to invest, regardless of interest rates.
Many people find starting investing daunting. There are many different options available, such as single stocks are investment funds. Additionally, you will also need a broker, such as SoFi. But this does not mean that investing is complicated, you can simply follow my guide.
Should you pay off debt or invest your money? Summary
When making the decision of whether to pay off debt or invest, interest rates are the most important factor. If the interest rate of your loan is higher than the anticipated growth of your investment, you should always pay off your debt first.
There are a number of other factors you may wish to take into account, such as security and accessibility. Additionally, mental health is another important point that you should take into consideration.
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