Pay Off Debt or Invest?

When you have extra cash, you’re often faced with a choice: pay off debt or invest the cash? These decisions depend on your unique needs and goals, so you’ll need to evaluate your options in that light. There are a few rules of thumb that can get you started in the right direction.

First, note that the question of whether to start investing only applies if you have extra cash. You’re making a choice between making extra payments to get rid of your debt faster or putting that money into some form of investment. Your regular loan payments should always come first.

If you do have some extra cash, it may seem like paying down debt is the obvious answer. The faster you pay, the less interest you have to pay over the life of the loan—that leaves more money in your pocket, right? Well, not always. As it turns out, it may actually be a better choice to keep paying the loan on schedule and instead put that extra money to work for you.

So how do you decide? Consider the following three factors:

1. Do You Have a Cash Cushion Saved Up?

One tip to keep in mind is whether you have enough of a cash cushion before tying up your cash in an investment. Most conservative financial pros recommend that working people have at least six months’ worth of monthly expenses in cash saved up before they invest.

Building your emergency cash cushion is important. Your cash cushion is your backup plan should you fall on financially lean times. An unexpected serious illness, loss of a job, or another emergency can require you to rely on your cash cushion, so you should make it a priority to save this amount before considering investments. This cushion can be your saving grace to help get you through financial or personal emergencies.

Experts say that your emergency cash cushion is especially vital to self-employed small business owners. Without a backup cash flow plan, any serious emergency may derail your business ownership plans. Saving for the proverbial rainy day can mean the difference between having to shutter your business and being able to withstand a serious financial bump in the road.

It can be frustrating to leave cash in a savings or checking account where it isn’t growing, but it’s a smart move. You should wait to invest until you have a comfortable amount of cash stashed away.

2. Consider Your Overall Debt-to-Income Ratio

When you’re trying to decide whether to invest or pay extra on your debt, you need to think about the total amount of debt you have. One of the most common (and easy-to-use) measures is a “debt-to-income” ratio, which is a comparison of your total amount of debt and your pretax income. Your debt-to-income ratio is a quick and easy check on your overall financial health.

In general, experts advise that a healthy debt-to-income ratio should not exceed more than approximately 30% of pretax income. In other words, if you earn $50,000 per year (pre-tax), you should carry no more than $15,000 in debt. If you owe more than that, you should always funnel extra cash toward paying down that debt. That 30% mark is just a rule of thumb and your financial advisor may recommend carrying more or less debt, but the idea is that a healthy debt-to-income ratio gives you room to maneuver if you have sudden expenses or an unexpected decrease in income. It’s a way to make sure you’re not being too aggressive and overextending your finances.

3. Compare the Interest You Pay With The Return You Could Earn

So what if you have a healthy cash cushion and debt-to-income ratio? Now it’s time to decide whether investing is worth it. Here, you need to compare the interest rate you’re paying on your debt with the return you can expect from your investments. Evaluate different portfolios and different types of investments to find what fits your needs and the level of risk you want to take.

Once you have an idea of the return you can expect, you need to compare it to your interest rate. If you can expect a higher rate of return for your investments than the interest rate you pay on your debt, then it makes sense to invest. If your rate of return would be lower than your interest rate on the debt, then it makes sense to pay down debt.

For example, say you have a loan with a 7% interest rate and you’re looking at a stock portfolio with a return of 11%. You could pay an extra $100 toward your debt and save a few dollars in interest payments, which is like making a few dollars (it will be less than $7 since you’ve likely already paid some interest on that $100 over time). Or, you could invest the $100 and make $11. Investing that cash is going to make you more money.

Remember that returns on investments aren’t guaranteed. The markets may underperform and leave you with a lower rate of return than you expected. That’s a risk you have to take in order to put your money to work for you in that way, but not everyone is comfortable doing that. Different kinds of investments (money market funds, bonds, stocks, mutual funds, and more) have different rates of return and different levels of risk, so find something you’re comfortable with.

As you look at your rates, consider whether refinancing your debt might be a good option. You may be able to secure a lower interest rate by consolidating or refinancing, so talk to your lender about that option before you do anything with your cash.

When making the decision to pay off debt or invest, it’s easy to get intimidated. Sometimes finding the right investment can feel like a risky or overwhelming process, so it can be tempting to make extra debt payments or just hold on to cash rather than try to dive into all that. But if you answered all the questions in a way that points toward investing, don’t let your fears make the decision for you. investing is getting easier all the time, with tons of apps and services to help people learn to invest and get started with small amounts of cash.