Make My Money Grow Part 3: Should I Invest Or Pay Off Debt?

pay off debt

pay off debtSome people are thrifty. Some are frugal. Both can be great at saving, and even at paying off debt. All wise choices. But saving is not the same as investing. Saving will pile up your money, while investing can make your money grow itself. But if you hold some debt, should you invest or pay off debt?

At the end of the post there is an Invest Or Pay Off Debt Calculator that will help you process as you decide which course to take.

It goes without saying-if you can’t pay your bills month to month you have no business investing at all. What if you have money left over after your paychecks? There are a few choices you have, and each can have a positive impact on your finances.

Want to make your money grow? Check out the last two weeks of this series:

How To Make Your Money Grow One: Educate Yourself
How To Make Your Money Grow Two: Invest Early

SHOULD I INVEST OR PAY OFF DEBT?

Option 1: Use all of your extra money to pay off debt

Of course, we should always keep some money in checking and savings that allows for liquid spending in case of an emergency.

Beyond that, if your interest rates are higher than 10%, you are likely to be much better off paying down your debt. Credit cards and other high interest loans may cost you more than the returns investments can bring.

As for a mortgage, it’s a great idea to make at least one extra house payment a year. Not only is it good for your psyche, but you can cut off an extra 5 years off paying your mortgage. That’s the inverse of compound interest!

The stock market has returned investor’s money with an 11% increase per year in the long-term. Short-term investing, Forex, Options trading and having faith in penny stocks hasn’t always brought about such an immediate return.

That 11% return sounds better than an 8% APR, right? That 11% in the long-term is far less if you consider fees and taxes, and there are no guarantees in the stock market. Your debt, however, is at a guaranteed rate.

Check this out: The stock market had a return of 8.71% between 2002-2012.

Option 2: Take all of your extra money and buy investments

There are those that hate debt so much and believe it is so evil they’ll burn me at the stake for saying this. But I believe in putting your money to work. If your debts aren’t costing you much—as in you’re beating 4% or 5% interest, you could be better served (remember: in the long run) by investing your leftover money rather than choosing to immediately pay off debt.

If you’re mortgage is costing you 5%, then logic is not served by buying a  bond or bond fund that yields 2%. But investing in carefully chosen stocks or mutual funds can have a better long-term payoff than 5%.

Option 3: Pay off debt AND buy investments

Warren Buffet’s teacher—Benjamin Graham—posits that we’d be wise to hold no more than three quarters of our investment finances in one asset class. (That’s referring to bonds vs. stocks). You can apply this logic to your “extra money.”

Digest this logic only if you have low-interest debt. Treat that debt like a bond. Then, you’d use a quarter of that extra income to pay debt off. You could use the remainder to invest. Or you could invert those numbers or mix them any way you like—take 75% of your extra money and pay down debt and invest with the other quarter.

RULE: Always Pay Off High-Interest Debt First

Without doubt, you should pay off debt that is high-interest first. If it’s complicated, scary, or just plain too much for one person to process, meeting with a financial planner is a good option. Financial advisers aren’t just for building an investment portfolio.

If you’re considering meeting with a financial adviser, they’re only as good as the facts you give them. Conceal nothing.

Got debt? Check out what Catherine says about it in Debt Consolidation: Rip-Off Or Real?
[Featured image credit http://dribbble.com/vlademareous]