Pay off debt or invest – which one is better? This is a very tricky question to answer as it depends on a number of factors that I will discuss later on.
I should point out that I am a big advocate of people avoiding getting into debt in the first place. I actually believe that even when purchasing a house you will be better off raising the funds yourself other than borrowing.
I have pointed out before that if you were disciplined enough and saved money for 15 years you could be able to purchase a house outright. You will however need to invest those savings in stocks or other profitable ways.
If you are doubting what I am saying just look at the people who invested in Amazon IPO in 1997. If you had invested $1000 your stock will be worth over 1 million dollars now.
I know that Amazon is an outlier due to its phenomenal growth but investing 500 dollars every month for 15 years should be enough to be able to buy a house outright.
My point is that we should all try to avoid debt as much as possible.
But today’s question is where you are already in debt. It could be student debt or any debt. The question is that if you are already in debt should you aim to pay off your debt or invest.
Compare the loan Interest versus Investment Return And Choose
All things being equal, I would compare the interest I am paying on my debt to the return I would get if I invested my money. If the interest on the loan is higher than the investment return then I would aim to clear the loan.
However, if the return on investments is higher than the loan interest then I would opt to invest my money and only pay the loan normally.
In any case, the interest rate on most loans is fixed while the value of your investment is subject to the economic conditions and other factors.
On average If you invest wisely you should be able to earn more money through your investment compared to the cost of your debt.
Like all investments one has to factor in the risk that you can lose your investment.
We have all seen companies such as Enron that looked promising but fell spectacularly without warning. Millions lost their life savings in the Enron scandal
How about the Bernie Madoff Ponzi scheme scandal that cost a lot of people their life savings too.
There is nothing clear cut about the stock market.
If The Debt Is Stressing You Out The Pay It Off
Recent events such as the Covid-19 epidemic have shown that our future financial wellbeing is not guaranteed. There are so many variables that can go wrong and we may find ourselves struggling to stay afloat financially.
It is with such things in mind that people are getting stressed about their debts. They are worried about losing their assets due to failure to services their loans when things go south during an economic crisis.
You cannot enjoy life when you are stressed and in such a situation the best would be to get rid of the source of the stress which is the debt.
If Your Are About To Retire And Will Have Cash Flow Issues Then Pay The Debt Off
If you are about to retire and will have no reliable source of cash then I would strongly recommend that you pay off all your debts if you can.
No one wants to go through his retirement wondering where he will get cash to pay his debts.
If it stresses someone in his prime it must be worse for a retiree. You don’t want to go through that when you are supposed to be resting and enjoying the fruits of your years of labor.
However, if you feel that your investments will still ensure a good cash flow then you can still keep on settling your debt normally.
Even though I feel that as a retiree you are better being free from debt.
As long as you have debt, your assets will always be at risk of being lost in the event that you fail to pay your debt.
Don’t Pay Off Debt At The Expense of an Emergency Fund
If you decide to pay off debt, you need to make sure that the paying off of debt is not done at the expense of an emergency fund. Emergency Fund are the sums that you put aside to cater to emergencies such as illnesses, funerals, etc.
I will be foolhardy for you to pay off your debt and have to struggle to access urgent medical care.
It is therefore prudent that in your zeal to clear your debt you don’t misuse your emergency fund.
Emergency funds are just important for illnesses and funerals only. They can be super important on other occasions too such as when you lose your job.
I have seen people crying after losing their jobs as they contemplated what the future holds for them. As they thought long and hard about how they will pay their rent or mortgage.
All this can be avoided if we forego some expenses on things we don’t need and instead used that cash to create an emergency fund.
I have an article on this blog where I discussed sinking fund categories that might help you in this regard.
Talks To Your Financial Adviser
If you have a financial adviser or can afford one then I would strongly advise that you meet your adviser before making your final decision on this matter.
As a layman, you may think you have it all thought through when in reality you may have missed out certain important details.
A financial adviser will be able to create a financial model that can show you each scenario. He or she may also have more information on how various markets are performing and their expectations for the future.
While these matters are not an exact science, financial advisers are still in a better-informed position that a layman. They may be able to see things that a layman cannot see.
And also these financial advisers have learned from the mistakes of other people in the past and can help you avoid those mistakes.
There is still room for experts in these days when experts are looked down upon.
In summary, I can say that the question of whether to pay off debt or invest is dependent on many factors. But all things being equal you will consider the return on investments versus the loan interest rate. Where the return on investment is higher than the loan interest then you should invest and vice-versa.
However, as I have pointed in the preceding paragraphs there are other factors that can affect your decision. For example, if you know that you may struggle cash flow wise in the future then you are better off paying off the debt while things are still okay financially.