Choosing between paying down debt or investing extra money is a complex decision. While each option has its merit, there are certain benefits to each. Your financial situation will play a significant part in this decision, with factors like risk tolerance and your financial goals also an essential factor. Â
In this blog, we’ll look at whether you should pay down debt or invest based on your financial situation.Â
Understanding debt and investment
There are certain factors to consider regarding debt and whether you should invest money rather than pay it off. These include:Â
Interest rates and type of debt
Firstly, it’s important to understand interest rates and their role in debt. For example, debts with high interest rates (such as credit card debt) can quickly spiral out of control. Because of this, you should endeavour to pay down high-interest debt as soon as possible or search for a lower rate.Â
Risk toleranceÂ
Your risk tolerance plays a significant role in your investment strategy. If you’re willing to take a risk, you may see high returns in the future. When considering investing, it’s important to understand the risk involved and the notion that nothing is guaranteed. Investing in something that has performed well historically doesn’t always mean it will perform well in the future. When you start investing, getting professional advice before jumping straight into the unknown is always best. While returns aren’t always guaranteed, a high-risk strategy can sometimes bring high rewards. Â
Financial goals
Your financial goals should be central to everything you do. Every financial decision (right down to how many cups of coffee you buy a day) should be made with your financial goals in mind. If, for example, your goal is to become debt-free, choosing to invest over paying down your debt may not be the right move.Â
However, if your goal is to earn a passive income to support your primary source of income, creating smart investments may help you achieve this.Â
Tax consideration
As with everything, tax considerations are always something to keep in mind. Tax implications on things like investment properties might be tax deductible, meaning that your after-tax interest rate will be lower than your regular rate. Capital gains tax is another aspect to keep in mind when looking to invest.Â
The 6 per cent ruleÂ
When researching, you may have come across something called the 6 per cent rule. Essentially, this ‘rule’ states that (for most people) paying down debt of 6 per cent or higher should be done before making any investments.Â
If your interest rate is less than 6 per cent, it may make sense to invest your extra money into investments for the future. This is because when interest rates are lower, there’s a higher chance that your long-term investment earnings will surpass what you’d get by paying back your debt faster.Â
Establishing a solid base
Establishing a solid base before you start any form of investing is crucial. Without having anything to fall back on, you jeopardise your entire financial well-being. To build a solid base, we recommend paying the minimum amount on all your debts, creating a strong emergency fund, capturing any employer match on your retirement savings, and paying off any credit card debt.Â
Benefits of paying down debtÂ
If you’re still on the fence, there are pros and cons for each strategy. Regarding paying down debt, some benefits immediately come to mind.Â
Firstly, depending on your investments, you might come out ahead if you have high interest rates on your loans. Next, your investment strategy can help you maintain a stable credit score. Your credit score is something lenders consider when deciding whether to lend you money, so showing you can maintain repayments is beneficial if you’re looking to get a mortgage or car loan in the future.Â
Lastly, paying off debt can improve mental health. If not under control, debt can be isolating and overwhelming and quickly spiral out of control. Your mental health can flourish by paying down your debt, knowing you don’t owe significant money. This also means you’ll have more discretionary spending.Â
Benefits of investing
If you choose to invest rather than pay down debt, ensure you do so in a way that will benefit you in the long run. For example, if you have a mortgage with an interest rate of 5 per cent and a stock market index fund that returns 10 per cent a year, you’ll come out ahead by investing your extra cash in the index fund rather than trying to pay down your mortgage.
Can I do both?
If both options sound appealing to you, you may be able to do both. Investing and paying down debt simultaneously can be a great strategy for meeting your financial goals and achieving a step forward to financial freedom.Â
One thing to note, however, is that if you have significant outstanding debt, you need to pay this off as soon as possible. If you’re struggling to maintain your debt, our Inovayt team can help you get back on track and devise a strategy to find your feet again.Â
How can an Inovayt professional help me decide?
The decision between paying down debt and investing your money should not be made lightly. Our team of experts has extensive experience with debt repayments and investing. We’ll work with you to establish your financial goals and develop a plan that works for you. Get in touch today.Â
