Should you pay down debt or start to invest with your expendable cash? Despite what Dave Ramsay may say, I do not think this is a one-size-fits-all question. I believe you should be able to evaluate your situation holistically before you come up with your answer.
So let’s examine the elements that go into this decision.
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What Kind of Debt Are We Talking About?
Have you run up high-interest credit cards on designer purses or shoes? To me, this is the worst kind of debt: high-interest status debt. If this is your vice, stop it! You have better ways to prove your worth than designer accessories. If you have this kind of debt, get rid of it first and learn to change your spending habits.
But are we talking about low-interest debt on a sensible car or home? A Home Equity Line of Credit for solar panels? To me, this is acceptable debt. This debt knocks itself out slowly but surely without breaking you in interest and fees.
I believe debt is like fat: some good, some bad. Look closely at the terms and what you are getting for this money. When I secured my first home mortgage, my father said to me, “Natali, you’re paying for money. It’s an acceptable service to pay for, but you should want the best deal on it.”
We all need to pay for money from time to time. The point is to minimize this effect on your monthly cash flow. In this economy, my rule of thumb is not to pay anything over 4% in interest unless it is an investment that I know will return more than that. Let’s discuss this trade off.
What Kind of Interest Rates Are You Paying on This Debt?
Albert Einstein said this of interest: “He who understands it, earns it. He who doesn’t, pays it.”
I find this to be an extremely motivating quote! The point being: You want your money performing for YOU and not for a creditor.
So weigh your options!
Do you have an investment that you know will perform at 10%? Great! Yet you have debt that you are paying at 17% interest? You’re losing money. Pay down the debt first.
Maybe you have an investment that you know will perform at 10% but have some acceptable debt at 5% interest? You’ll still be making 5%! Make that investment!
We recently bought a family car (because we are expecting our third child and needed a third row, God help us!). We financed half of it at 2.99% interest. To me, this is debt worth carrying because we got a safe car out of the deal and our investments do way better than that.
You want to weigh your investment option against your debt service like a scale. See how you come out year over year.
Can You Use Your Investment Cash Flow to Accelerate Your Debt?
Maybe your debt and your cash flow are going to be pretty even. For example, your rental property
pays you $600 per month (after taxes and insurance), and your debt service costs you $450 per month. Can you use the extra $150 to pay down your debt service faster so that the entire $600 per month is eventually yours to spend? How long will that take? How long can you afford to take a small profit until it is all profit? Run the numbers!
Remember this: Every parenting book I’ve ever read (and I’ve read A TON) tells us to teach our kids delayed gratification
if you want them to succeed in life. We need that, too. Can we invest in something and wait for the payoff? Can you live on little cash now to see big rewards later?
In my experience, buying into your investment portfolio sooner rather than later is usually better. Your debt should not be your excuse to wait. If you wait too long, deals go by you in the fast lane. Of course, you don’t want to strap yourself so thin that you can’t buy groceries. But you don’t want to watch other people make money from the sidelines. You must be continually weighing your options and ready to take a leap sooner than later. I hate to end with a cliche but it is true: Fortune favors the bold.
[Editor’s Note: We are republishing this article to help out our newer readers.]
What do you think? Under which circumstances should someone pay off debt first? When is it better to use funds for investment?
Let me know your thoughts with a comment!