If you have some extra cash flow each month, you may be wondering what’s best to do with it: Invest it or pay off debt.
Remember, taking too long to pay off debts means paying more in interest and finance charges. Plus, debt is uncomfortable. Taking too long to invest can also have similarly serious consequences – gains don’t have time to compound and create a meaningful retirement nest egg.
The answer as to which path to take can either be complex or deceptively simple – depending on your financial situation. In this case, making the right decision means getting yourself out of debt quickly while taking advantage of compounding gains in the market. It also means that you should only invest before paying the debt if you can earn more on your investment than you’d pay in interest on your debt.
Before you start putting your money toward either investment or paying debt, it’s essential to make sure you have your financial basics covered
There are a lot of emotions involved when it comes to making financial decisions – this is straight-up what you should do to optimize your finances;
Do the Math
Just like everything else in your finances, deciding how to best use your money is all in the calculations. Take a look at your debt and calculate exactly how much it will cost you to pay it off. Be sure to include any interest, fees, and penalties into these calculations.
Next, take a look at your after-tax rate of return on any investments you may be considering. Unless you’re investing in a tax-free bond or a tax-sheltered account, you will most likely need to pay taxes on your earnings, which could decrease your actual return, so keep that in mind. Since the question is whether to repay debt or invest, you want to compare two numbers: the difference between the cost of your debt (primarily interest charges) with this hypothetical additional payment and the cost of your debt without any extra payments; and the potential return on your investments.
Examine Your Financial Situation
Before you start putting your money toward either option, it’s essential to make sure you have your financial basics covered.
The best way to do that is to create a budget so that you can see how your monthly income is used. Some experts recommend using a 50/30/20 approach to your budget: 50 percent of your income goes toward necessities (food, shelter, utilities, and so on), 30 percent toward discretionary spending (optional expenses), and 20 percent toward savings and debt payments.
That’s just the starting point, however: Depending on your situation, you may need to reduce your discretionary spending to focus on eliminating debt or saving to invest or for the future.
Pay the Minimums on All Debt
Given that your payment history is the biggest factor in determining your credit score, and that your credit score impacts so many areas of your financial life, making at least the minimum payments on all your debts on time is the priority.
Doing so will help you build a positive credit history, and more importantly, it will keep you from unnecessarily damaging your credit and making the rest of your life more difficult.
Pay off High-Interest Debt
It’s reasonable to expect a balanced portfolio to produce long-term returns in the range of 6 percent to 7 percent, but that’s not guaranteed. It could be higher or it could be lower, and either way, the journey will be full of ups and downs.
On the other hand, the return you get from paying off debt is certain. Putting extra money towards a loan with a 10 percent interest rate earns you exactly a 10 percent return.
That certainly makes it an easy win to pay off high-interest debt before contributing extra money towards your investment accounts. If you can get a guaranteed return that’s greater than or equal to the expected, but non-guaranteed, long-term return of your investment portfolio, it’s really a no-brainer.
Build an Emergency Fund
No matter how much debt you have and what the interest rates are, it’s a good idea to build a small emergency fund before you start making extra payments.
The reason comes back to sustainability. Unexpected expenses will come up whether you want them to or not, and having some cash on hand will allow you to handle them without interrupting your plan and without having to resort back to debt.
Experts generally recommend having three to six months’ worth of expenses set aside in an emergency fund.
For some people, though, it can take years to accumulate enough cash to achieve that goal, so consider starting with at least KES 100,000 or KES 200,000 as a small buffer, then continue to build your safety net while working toward other financial goals as well.
Snowball Debt Payments into Your Investments
This is a key point that often gets overlooked. If you really want to get the most out of all of this money you’re putting to work, you have to invest what you would otherwise put towards debt once it is paid off. That is if you’re putting KES20,000 a month towards your debt, once that debt is gone you need to invest that KES20,000. The reason for this is that while paying off debt can provide a better return to investing, it only does so for the life of the loan. Investing, on the other hand, typically provides decades of compounding returns that you’ll miss out on if you stop contributing as soon as your debt is gone.
It Doesn’t Have to Be All or Nothing
As you approach saving, investing, and paying off debt, keep in mind that you don’t have to focus on just one thing at a time. If you do, it could end up taking longer to start working on each of your goals, which could delay your success.
Look to find a balance between your savings, investing, and debt payoff plans. While it can take a little longer to achieve each goal this way, it can give you a more well-rounded financial foundation and pay off in the long run.
Finally, keep in mind that investing doesn’t come with guaranteed growth. Any average or likely rates of return you may see are often based on long-term performance, and you may experience higher highs and lower lows—even negative growth—in the short term.