Whether it’s a mortgage, personal loans, credit cards or all, today more and more people are drowning under the weight of debts. And, for those who have enough income to stay afloat, the only logical option seems to be paying off their debts as quickly as possible.
But wait, is paying off debt QUICKLY, really the best financial solution?
While it definitely feels good to be debt-free, in some extremely rare situations, you might do better simply by keeping your debts (for example, making minimum payments on your loan) and investing the money you have left over. Fortunately, there are some basic principles you can use to help you determine whether to invest or pay off your debts.
Learning the difference between “good” and “bad” debt
Make a list that includes all your liabilities. Gather your financial statements and make a list that includes all your debts. The list should include the following:
- Name of the company you borrowed the money from
- Outstanding balance of the loan
- Minimum monthly payment
- Expected date on which the loan will be repaid in full
Create a list of everything you bought with borrowed money. You’ve probably used most of your debts to make purchases. Make a list of everything you paid off with a loan. If you can’t remember everything you bought with your credit card, just write down “credit card purchases.
Combine the two lists to create a master list that connects your debts to your purchases.
For example, if one of your debt is a Visa credit card, make a list of the purchases you made with that card under this heading.
If you bought a house with a mortgage, place the house under the heading “mortgage. Anything you label as “credit card purchases” from the previous step is considered bad debt. People rarely use a credit card to buy something that increases in value over time.
Separate good debt from bad debt. All of your debts will be classified into one of two categories: good debt or bad debt. This is based on the following criteria:
- If the purchase involves something that normally increases in value over time, it’s good debt. Examples of good debt include your home, your college education, renovations and fine arts.
- You accumulate bad debt when you use credit cards or other debt to establish or maintain a lifestyle that you might not otherwise be able to afford. Purchases you no longer remember or use, such as entertainment, travel, or basic living expenses, are examples of bad debt and living beyond your means.
- Borrowing to buy a new car is considered bad debt because its value depreciates rapidly and interest rates can be very high.
Deciding Whether to Invest or Pay Off Your Debts
Eliminate all your bad debt before you invest. The reason you should eliminate bad debt before you start investing is that you have a double expense associated with bad debt.
- Purchases made with bad debt include items whose value decreases over time, so you lose money as those items depreciate.
- Purchases made with bad debt can have a high interest rate associated with them, so you lose money by paying an interest expense. In the case of credit card debt, that expense can be quite high. However, just because something is interest-free doesn’t mean it’s good debt. An interest-free loan for an expense or a depreciating asset could be bad debt.
- If you invest while you still have bad debt, you run a risk with money that could add to the losses you already experience.
Invest once you have only good debt. If all the debt you have is good debt, you can invest because you’ll normally see an appreciation in the value of things bought with that debt.
- If you bought a home with a mortgage, that home will generally increase in value over the long term (although this is not guaranteed). This increase in value will offset, to some extent, the interest you pay on the mortgage.
- If you still have college loans, you invested in your career. Your salary should increase over time as you gain more experience or are promoted.
- However, consider that good debt doesn’t always give you the returns you expect. The real estate market has proven not to be as constant as once thought. And more and more college graduates find that their degrees don’t guarantee a good job. You have to examine the cost of good debt versus the expected return on investment. For example, it might be better to pay off a good debt with a high interest rate if your potential return on the investment is less.
Avoid incurring more bad debt once you start investing. If you have to, liquidate some of your investments to buy items that diminish in value. However, avoid incurring more bad debt with losses that reduce your investment earnings.
A car, for example, may be a necessity wherever you live or for your lifestyle. But borrowing to buy the newest, most lustrous car is considered bad debt. Cars are expensive, depreciate quickly, and the interest you pay is a waste of money. To avoid this, either pay cash for a reliable used car or get a loan with very little interest and buy a cheap car that you can pay for fairly quickly.
Look at the big picture. Debt can be overwhelming and stressful, and for the most part, it’s best to get out of it completely as soon as possible. However, paying off certain debts isn’t always the best long-term decision. Don’t get so obsessed with paying off your debts that you don’t look at the big picture.
Sometimes it’s worth keeping your mortgage for tax benefits. For example, paying off a second home by taking money out of your retirement plan may seem ideal because you won’t be in debt. But in fact you must pay taxes to get money out of your retirement plan. In fact, it may be better to have a mortgage on your home and get a tax break.
Plan carefully for your retirement. Most people retire with a little debt. This is fine as long as you’ve carefully planned your finances for after retirement so you can pay off these debts. Experts recommend having a retirement spending plan that includes being able to pay off your debts. This may mean that you have to work a few more years than you’d like. But you’ll save yourself the stress and long-term financial hardship.
- If you’re married, make sure you and your spouse agree on a plan of action. When in doubt, pay off debts first and come to a compromise. Perhaps the more careful of the two will favor starting to invest when the debt decreases beyond a certain point.
- Being debt free allows you to invest more aggressively and be more generous with your charitable donations.
- Look for others who are enthusiastic about reducing the debts in their lives and meet with them regularly. Develop responsible partners who can help you make decisions about major purchases and accompany you as you get out of debt.
- Consult a professional. Many professional accountants and counselors are available to help you devise a plan that will allow you to save for your future by also paying off current debts.
Investments carry risks and choosing to use your money to invest rather than pay off your debts more quickly is inherently risky. Of course, the amount of risk depends on the investment, so you have to consider each investment opportunity carefully. Also remember, however, that neglecting your retirement savings (even if doing so pays off your debts sooner) is also risky.
Most of those online calculators assume that your investments will go well and do not take into account the risk involved. If the investment doesn’t go well, you may find yourself paying off your debts sadly having little or nothing to show for your “savings.
Never borrow money for the sole purpose of investing it. Most (if not all) investments do not have a “guaranteed” rate of return. All loans will require you to pay interest. It is very easy to get caught between a low return investment and a higher interest loan.