Million Dollar Question: Should You Pay Off Debt Before Investing?

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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.

Step I: Analyze your debt.

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:

Put together a list of your debt.

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.

Identify tax deductions on your debt to calculate the effective rate of interest.

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.

Step II: Identify your investment options.

Now that you have a clear idea of your debt, it is time to find out any potential investment opportunities that you may have.

Create a list of investment options.

 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.

Rank investment options based on their average return on investment.

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.

Find out applicable taxes on returns.

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.

Find the effective yield of investments.

You need to factor the applicable taxes on your investment returns.

Take into account your risk profile.

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.

Step III: Compare debt and investments.

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.

Step IV: Take into account behavioral economics.

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.

Source: Global News
Source: Global News

 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.

Step V: Pay off debt or invest.

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:

  • You start paying off debt with the highest rate of interest first while investing in instruments that offer additional financial benefits. For instance, contributing to your employer-sponsored retirement plan that offers matching contributions helps you take additional money off the table.
  • As your higher-interest debt is paid off, distribute your income towards debt payments and investments, prioritizing the one that offers a better return on your money.

Bonus Tip: Use 50/30/20 rule for budgeting.

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.

The Bottom Line

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.

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Jenna West

Jenna West has built up a list of published work on various global recognized websites like RE/MAX Canada, Freeman Audio Visual Canada and now carries the title of Freelance Content Manager for Smarter Loans. Jenna adds creative value and fresh perspectives on all things finance, especially pertaining to millennials, and has a natural knack for turning a page full of words into a visual reading experience.

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