In the event of a financial windfall, an immediate question that springs to the mind of most is whether to invest that extra cash or pay off existing debts instead. Depending on the situation, either option can be a reasonable strategy. In some cases, doing a combination of paying off debt and investing can also make sense. Today, we will list some of the key factors that should inform the decision to invest or pay down debt.
What Kind of Debt?
The specific type of debt a person has should influence their decision to invest or pay off their debt. For instance, a mortgage is generally considered to be ‘good’ debt, since it relates to an investment in your home and usually has a low interest rate (most likely lower than 8 percent). On the other hand, things like credit card debt tend to be treated as ‘bad’ debt since they usually have a high interest rate (in the double digits) and will end up costing more than double the original payment over the long haul if not quickly paid off. Credit card debt often carries an interest rate above ten percent, even topping twenty percent, and few investments can ever consistently match that with their rate of return.
How Much Debt, How Much Interest?
Along with the kinds of debt a person has, the amount owed should be considered when deciding whether to pay it off or invest instead. In general, the more debt you have, the greater your credit utilization rate, and the more you utilize your available credit there is the potential for your credit score to take a serious hit. A worse credit score can end up crippling your financial prospects and make life much more difficult moving forward. Paying down your debt is usually a sensible way to help protect your credit score.
Paying Down Debt is Financially Freeing
It probably does not need to be restated but paying off your debt typically enables you to be much more financially free and capable. Without the added monthly or annual expense of servicing a debt, many people can save more money towards their retirement or make significant purchases to improve their quality of life. For many, paying down debt is the single best thing they can do to improve their financial health.
Investing Offers Opportunities
Conversely, for some people, investing is a great tool to generate savings toward retirement and long-term wealth accumulation. While most investments are unlikely to generate returns that can beat or match the high interest rates on things like credit card debt, the opportunity investing offers to save and accumulate interest over many years or decades is attractive enough to warrant serious consideration.
If the kind of debt an individual has is small and has a lower interest rate, it might make sense to invest a windfall rather than pay down the debt. As a rule of thumb, most advisors expect to see a diversified portfolio generate a return of seven to eight percent annually—though, of course, no returns are guarante4ed.
Many investors choose to contribute to their portfolios instead of paying off their debts if the accumulated interest rate on their debt is less than seven to eight percent. Things like mortgages and student loans typically have interest rates lower than seven percent, so many individuals with mortgages or student loans as their principal source of debt choose to invest newly acquired cash instead of paying off these obligations.
Why Not Both?
As a middle ground between the two extremes of completely investing new cash or completely paying off debt, many individuals choose to split a windfall between the two options. A typical compromise strategy would be to put about half of any windfall into investment vehicles and to use the other half to pay down debt with the highest interest rates. Since not all investments are equal, an efficient use of new income may focus on reliable, low-risk investments like mutual funds or even bonds.
At the end of the day, a sudden injection of new cash into a portfolio or debt payment is generally a good thing. The question of which is better is often best answered according to individual circumstances. The general rule of paying down debt with the highest interest rate and investing in low-risk assets that will generate significant returns over a long period (typically a decade or more) is usually considered to be the soundest plan for individuals who are not currently financially insolvent.
Speak with a Financial Advisor
At The Templeton Group of Cornerstone Financial Management, we are experienced financial advisors in Columbia, SC, ready to help you create a plan to work toward financial success while you focus on life’s other priorities. Contact us today to request a consultation.
Disclosure
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.
