Investing versus paying off debt
Every so often, I am asked the question “Should I pay off my debt or invest?”
This is a question that most investors will wrestle with at some point in life. Recent college graduates, by way of illustration, might wonder if they should pay off their student loans as fast as possible or start a retirement plan. Other investors may deliberate whether or not it makes sense to pay off a home mortgage early. Conventional wisdom says you should do whatever gives you the best return on your money. After all, why would you pay down debt that carries a low rate of interest, if you can invest your money and make a higher rate of return?
The answer to the question posed in the opening line of this article, perhaps not surprisingly, is “It depends.” It depends because every investor is different; every situation is different; and the answer is not always measured in strictly dollars and cents.
More often than not, I find non-monetary factors weigh heavily in these decisions. For instance, some people believe it is important to invest in an attempt to maximize the return on every dollar, whereas others feel a sense of peace by being debt-free.
My goal as a wealth manager is not to persuade all of my clients to think exactly like me. Rather, I attempt to help clients understand the potential benefits and pitfalls of the choices facing them, and to provide guidance that assists them in reaching their financial goals. For the purposes of this article, I will respond to the question as though I am answering it for myself. These are steps that I have tried to follow over the course of my life.
At the very least, cover your minimum debt payments because that is the honorable thing to do. You borrowed money, and committed to pay it back. Therefore, do everything within your power to keep your promise. Work more hours; take on a second job; and by all means, live a simpler, less extravagant lifestyle.
Create an emergency fund. Financial planners often say this should be six times your monthly income needs. If you have steady employment with a financially strong employer, then you can probably get by with less.
If you have a retirement plan that provides an employer match of some sort, then seriously consider investing enough to take advantage of the full match. In some cases, employers might double the amount of money you invest. In this scenario, for example, your rate of return would be so high that I believe it makes sense to invest rather than pay debt off early.
Consider buying term-life insurance if you have loved ones who would be financially hurt by your demise. I have seen spouses and young children saddled with debt because the primary bread winner died without adequate life insurance. I would not want that to happen to my family.
Consider buying disability insurance. For younger people, the odds of being disabled are often estimated to be higher than the odds of dying. However, many often overlook the importance of insuring one’s earned income from car crashes, everyday accidents and sickness. I know people who became disabled, at relatively young ages, without disability insurance. Their lives have been financial challenging ever since. I would not want that to happen to me.
Completely pay your smallest loan first. Then, take that payment and apply it to your next smallest loan. Continue to pay off each successively larger loan with the loan payments of all paid off loans. Don’t worry that you are not paying off your highest interest loan first. Mathematically, that makes sense. However, there is a major psychological boost that comes from having fewer and fewer loans. Plus, this is a really simple and easy strategy to follow.
Save for a down payment on a house or contribute 10 percent to a retirement plan. If you have the ability to save the required down payment for a house within two years, then I suggest focusing on just that. Keep the money in the bank, and don’t take any investment risk because you will need the money in only two years. If it is going to take longer than two years to save for a down payment on a house, then set aside some money for a down payment and some money for retirement. Ultimately, you don’t want to pay rent for the rest of your life. Instead, your financial goals should include making payments for your own home while still having enough money left over to save 10 percent toward retirement, give to charity, and maintain an enjoyable lifestyle. Depending upon your values, you may be willing to reduce one or more of these goals to begin a college education for your children.
If you are financially comfortable, then the decision to invest or pay off debt comes down to the interest rate and terms of the debt, the risk and potential rate of return of the investment inclusive of any tax advantages, and how quickly you can get out of the investment if it goes against you. Again, there is no one “right” answer.
This article was written by Ken Levy, a certified financial planner professional and a principal with Levy, Daniel & McGee Wealth Management. Wells Fargo Advisors Financial Network is not a legal or tax advisor. Levy, Daniel & McGee Wealth Management is a separate entity from WFAFN.