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When it comes to debt, you can always hear different opinions. Some financial experts are strong supporters of the zero-debt life, Dave Ramsey or Mark Cuban, whereas others suggest taking a hybrid approach, i.e. pay off debt while investing. If you have debt, it is quite likely that you have somewhat similar thoughts, and it could be daunting to choose between them. Here’s a short exercise that can help you choose the most suitable option.
Since debt could create severe issues for your financial health, we’re going to be very clinical in our analysis. Here is what you need to do:
You can use a spreadsheet, or a pen-paper will also do. List debt with the highest rate of interest at the top, such as credit card debt, and move down to low-interest debts sequentially, such as a home loan.
It is critical to understand that different tax deduction laws apply to the US and Canada. For instance, the US government allows homeowners to deduct the interest they pay on mortgages, up to a certain extent, whereas the Canadian government allows homeowners to pocket the capital gains at the time of selling the house. Find the applicable tax deductions and factor it in your debt repayments. Adjust the list after factoring in these deductions.
Now that you have a clear idea of your debt, it is time to find out any potential investment opportunities that you may have.
It can include investment assets such as mutual funds, government bonds, index funds, private investment options, and business opportunities for professionals or self-employed individuals.
While it is easier to rank fixed-income or fixed-interest assets, ranking equities could be tricky. We’re going to do what investment managers do; analyze the past rate of return of the investments. Once you have the average yield for all the asset classes, rank them in descending order, with the investment having the highest rate of return at the top.
Just like we identified any tax deductions, we have to find any applicable taxes on your investment returns. It is critical to understand that tax rules vary for interest income, dividends, and capital gains, so be careful with the calculation.
You need to factor the applicable taxes on your investment returns.
Just like your financial choices, your risk profile is unique, or at least different from others. If slight market movements leave you sleepless at nights, you, probably, have lower risk tolerance. On the contrary, if you’re okay with average market volatility and prefer long-term returns, your risk tolerance is high. Depending on your individual risk profile, rank investment options that suit you the most at the top, and adjust your investment list accordingly.
You should have two tables at this step, one that lists your debt and the other one with your investments. Compare your effective rate of interest on debt with the net yield on your investments. For instance, you’re likely to pay between 19% and 29% on your credit card debt, whereas your average return on emerging markets’ investments stands at 10.5% between 1987 and 2018. Now, if you have an excellent credit score and get an annual percentage rate (APR) of 15% on your credit card rate, you’re still paying more in interest than you’re making on your investments. Apply the same logic to the rest of the list and identify what makes more sense.
The smart money suggests paying off debts with a higher rate of interest first instead of investing. It makes perfect economic sense, but then, we’re driven by emotions than pure logic. Follow the next step to find your answer.
In spite of what logic suggests, people often let their emotions influence their financial decisions, let it be debt or investments. Robert Kiyosaki has the perfect quote depicting our economic choices.
“10% of the borrowers in the world use debt to get richer – 90% use debt to get poorer.”
If your current debt takes a toll on your mental health or adds to your stress, it makes sense to repay the debt first.
If you fall under this category, paying off debt could be a huge relief. It is critical to take into account your personal take on debt and its effect on your life before making a decision.
Now that you are aware of every aspect of your financial life, you’re ready to make a call. Understand that both of these actions have their benefits and pitfalls, but it’s critical to choose the one that gives you mental relief.
Some financial experts suggest taking a hybrid approach. Under the hybrid approach:
Since you need to manage your finances better to execute your plan, it is the right time to create a personal budget. Under the 50/30/20 rule:
Allocate 50% of your income to necessary expenses. This will include grocery, utility bills, rent, and other critical household expenses.
Use 30% of your salary for personal expenses.
The remaining 20% should either go towards investments or debt payments.
Financial experts suggest making long-term investments along with the repayment of your debt. It ensures that you are leveraging the benefits of compound interest.
Financial decisions aren’t easy to make especially when they can affect your day to day life and future, so it’s absolutely alright to feel a little overwhelmed. The ideal strategy is to pay down your debt while investing enough funds for a comfortable retirement. Whenever in doubt, take financial advice. Financial experts rely on logic instead of emotions, so ask them for a solution. Always remember, you’re more than capable of getting rid of your debts and building a promising future.
