Expendable income is a hotbed of debate: should you use that cash to pay off debt or should you invest it? While some financial advisors adamantly advise you against more debt, other advisors encourage the use of "good debt" through investing. Indeed, many investors struggle with this dilemma. In order to make the best decision, ask yourself these three questions when considering how to spend your disposable income.
What kind of debt do I have? What are the interest rates?
The word “debt” is often seen as a dirty word, but the truth is there are a lot of forms of debt. Before you can access whether you should reduce your debt or invest, first deduce what type of debt you carry. Is it a high interest credit card debt? Do you have a mortgage or a reasonable car payment?
The key here is to crunch the numbers. Compare the interest rate of your current debt to the return rate of the proposed investment. Which is bigger? If the investment promises a return of 10% but your credit card interest rate is 22%, it is more prudent to pay down your debt first. On the contrary, if an investment promises 30% and the interest you owe is 5%, you are smart to make the investment. Let the numbers guide you.
What is the risk associated with the investment?
Is there a risk to paying off the debt first?
Analyzing the risk associated with an investment is an important factor when deciding to pay off debt or invest. Paying down debt is a guaranteed way to save money: you no longer need to make monthly payments and you are not losing money by paying interest. Consider the potential success of the investment? No investment is ever 100% guaranteed. Reduce your risk by thoroughly researching all aspects of a potential investment. Perhaps investing in Uncle Bob’s traveling Popsicle stand in Alaska isn’t the best use of your money. On the other hand, investing in a new facility to allow an already-established textile business to grow and therefore become more profitable is much less risky than a frozen treat stand in Alaska. Be smart about your investments.
In addition to analyzing the risk of the investment itself, it is equally important to consider the risk of aggressively paying down debt. Using all of your available funds to pay down debt can become problematic. For instance, if you lose your job or are injured and have no available cash, you might struggle to pay bills or utilities. Tip: Keep at least six month’s worth of expenses in a savings account. Use that for emergencies.
Can your investment help to reduce your debt?
One of the best pieces of financial advice is this: make your money work for you. Good debt is a tool that can be used to create wealth. A smart investment creates a passive income.
A great example of passive income is seen with real estate investments. Imagine that you purchase a duplex with the intention of renting out the units for $1000 each. If the mortgage you owe on the duplex each month is a total of $850, you will have $1150 left over. The $1150 can be applied, in part or in full, to your previously existing debt.
Using your investment to pay off your debt not only accelerates the rate at which you pay off the debt, but it is done passively – with minimal effort on your part.
In short, there is no “one size fits all” solution. Deciding how to allocate our funds is often a difficult decision. Between the risks associated with investing and the sometimes-crushing weight of debt, it can seem like a Magic 8 ball might have the best answer – but that is not the case. By carefully and honestly evaluating your debt and the interest it carries, the associated risks, and the possibility of an investment paying off your debt, you can come to a well-informed decision on investing versus paying off debt.
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