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People who find themselves with extra cash can face a dilemma. Should they use the money to pay off—or at least, substantially pay down—that pile of debt they’ve accumulated, or is it more advantageous to put the money to work in investments that will grow for the future? Either choice can make sense, depending on the circumstances.
Key Takeaways
- Investing and paying down debt are both good uses for any spare cash you might have.
- Investing makes sense if you can earn more on your investments than your debts are costing you in terms of interest.
- Paying off high-interest debt is likely to provide a better return on your money than almost any investment.
- If you decide to pay down debt, start with the debts with the highest interest rates and work your way down from there.
Investing vs. Debt Repayment
Investing is a way to set money aside for the future, ideally in an investment vehicle—such as stocks, bonds, or mutual funds—that will grow in value over time.
Debt, on the other hand, represents money that you’ve already spent and that a lender is charging you interest on. Left unpaid, that debt will grow and grow, with interest charges adding to your balance and incurring interest charges of their own.
The Case for Investing
As a general rule, if you can earn more interest on your money by investing it than your debts are costing you, then it makes sense to invest. For example, if you have a mortgage with an interest rate of 5% and a stock market index fund that is returning 10% a year, you’ll come out ahead by investing your extra cash in the index fund.
On the other hand, if you have credit card debt at 20%, you would be better off putting your extra cash toward paying that debt rather than investing it in the index fund.
Unfortunately, it isn’t always that straightforward. Investments can be volatile. That index fund might be up 10% this year but down 10% next year. While there are investments that pay a guaranteed interest rate, such as bank certificates of deposit (CDs) and U.S. Treasury bills, they tend to have low rates of return that rarely exceed the interest rates charged by credit card companies and other lenders.
Another factor is more psychological: your risk tolerance. If you are comfortable taking the gamble that your investments will bob up and down with the markets, sometimes rising in value and sometimes losing value, then you are a better candidate for investing than someone who would lie awake at night worrying about what the market might do tomorrow.
The Case for Paying Down Debt
There are several good arguments for choosing to pay down debt rather than investing. The first, as mentioned above, is that you might come out ahead if your debt carries a relatively high interest rate. That’s especially true with credit card debt. Average credit card rates tend to be in the mid-20% range. Few investments can match that rate of return.
Another solid reason to pay down debt involves your credit score—a number that can be very important if you want to borrow money in the future, such as for a mortgage or a car loan. Having a low credit score can mean paying higher interest rates if you can get a loan at all.
Your credit score can even affect other aspects of your life, such as the premiums you’ll pay for insurance, whether a landlord will rent to you, and even whether an employer will hire you.
Fast Fact
If you’re a student, be careful of private loans, as they are generally less flexible than federal student loans.
Credit scores are based on several factors. In the case of the most widely used one, the FICO score and your credit utilization ratio—the amount of credit you are currently using compared to how much credit you have available to you—account for a significant portion of your score.
So, for example, someone whose credit cards are all maxed out is likely to have a considerably lower score than someone whose credit cards have been paid off or at least paid down to a more reasonable level.
Paying off debt, particularly if you have a lot of it, can be a smart move for that reason alone.
As with investing, psychology comes into play here, too. If you’re losing sleep over your debts, then you could be better off repaying them—even if you might get a better return on your money by investing.
The Case for Doing Both
Paying down debt versus investing doesn’t have to be an either/or decision. You can, and sometimes should, do both. For example, if you don’t already have an emergency fund, you might want to use some of your money to create one, while using the rest to pay down your debts.
A good place to keep your emergency fund is a low-risk and highly liquid (that is, easily and quickly accessible) investment, such as a money market mutual fund.
How to Pay Off Debts
If you’ve decided to use your spare cash to pay off your debts, the next question is how to go about it. If you have enough money to cover everything you owe, the answer is simple: Pay it off. However, if you don’t have that much cash to spare, then you will need to prioritize.
Generally speaking, you’ll get out of debt faster if you start paying off your debt with the highest interest rate first and work your way down. For example, if you have balances on two credit cards, one charging you 20% and the other charging 15%, tackle the 20% balance first.
Regarding credit card debt, you may also have another option: Transfer your balances to a card with a lower interest rate, then pay them off. Some balance transfer credit cards offer promotional periods of six to 18 months when they charge 0% interest. This can help you pay your balance down faster since you won’t be incurring additional interest.
Still, another option is a debt consolidation loan from a bank or other lender. This works by allowing you to borrow enough money from the lender to pay off your other debts.
Now you just have one debt to worry about, ideally with a lower interest rate than your prior debts. You can then use your extra money to begin paying off that loan. Investopedia also publishes ratings of the best debt consolidation loans.
If You’re Really Deep in Debt
If your spare cash won’t begin to make a dent in your debt, then you may need to consider some more drastic measures. First, if you’re having trouble making even the minimum monthly payments on your credit cards or other loans, contact your lender. It may be willing to reduce your minimum payment or the interest rate on your debt.
A second option is hiring a reputable debt relief company to handle negotiations for you. This is an area that’s rife with scams, so make sure you know who you’re dealing with.
As the Federal Trade Commission notes, “These operations often charge cash-strapped consumers a large up-front fee, but then fail to help them settle or lower their debts—if they provide any service at all.”
How Can I Pay Down Debt?
There are a few strategies to pay down your debt. You should start by tackling your highest-interest debt first, as that can cause your debt to continue to grow. It’s essential to have a budget to understand how your money is spent. After creating an emergency fund and covering your basic expenses, save additional money and use it to pay down debt. This can include a bonus at work or a tax refund. Seeking your creditors about better payment plans or lowering your interest rate. You can also seek to consolidate your data to make it easier to manage.
How Can I Start Investing?
Starting to invest is a reasonably straightforward process. The easiest way is to open a brokerage account at an online brokerage, such as E*Trade or Fidelity. Next, deposit money into your account. This can usually be done directly from your checking account. After that, decide what you’d like to invest in, such as stocks, and which stocks you’d like to purchase. Once you’ve chosen, you can place a purchase order on your broker’s website.
What Types of Debts Should Be Avoided?
Not all debt is bad. Buying a home, for example, usually involves a mortgage, which is a form of debt, but it also helps you build equity through homeownership. Additionally, the interest rates are generally manageable. You should always avoid high-interest-rate debt, such as credit cards or payday loans, which are challenging to pay off every month. Due to their high interest rates, your debt can spiral out of control and be difficult to rein in.
The Bottom Line
Having some extra cash is an enviable situation. Whether to invest that money or use it to pay down your debts is a decision that only you can make. But either use is better than simply spending it. Whichever course you take, you’ll be in a better financial situation than you were in before.
