If you get a windfall or are trying to figure out how to prioritize your financial goals, you may be struggling with the decision of whether to invest or to pay off all that debt. Both are important if you hope to retire someday, living out the rest of your years enjoying the freedom it brings and a comfortable lifestyle.
A survey by Lending Tree found that given $10,000, the majority of Americans would use it to pay down debt. Investing your money allows you to build a reserve that protects you and your family, providing sources of passive income while accumulating enough to retire comfortably. Paying of your debt means less stress, more flexibility and a better ability to roll through inevitable bumps in life like a financial emergency. When your debt-free, should an economic recession occur, you’ll be more likely to make it through relatively unscathed too.
But it’s a little more complicated than that, there is no one right answer for all.
Questions to ask yourself
You’ll need to compare the after-tax rate of return that you expect to earn on the investment to the rate of after-tax interest you’re paying on your debt. Which number is greater? The interest you’re paying, or the return on your investment? If you’re paying more in interest than you’d be able to earn, the obvious choice is to pay down your debt.
Let’s say you owe $5,000 on a credit card, and you have $5,000 in the bank that you can use which will make you totally debt-free. The interest rate on the card is 10%, and the bank is paying 1%. While paying off the credit card probably seems like the obvious choice, that’s not always the case. For example, your sister has a “can’t lose” business and wants you to invest that $5,000 in her organization. She says that investments are earning 30%. Paying the credit card off means a guaranteed 10% earnings as that’s money you’ll be able to keep in your pocket. Investing in your sister’s business brings no guarantees – you could very well earn that 30% or even more, but there’s also the chance that you’ll lose everything. That means you’ll need to assess the risk – what are the odds that your investment will pan out – if you think they’re very good, go for it. If not, it’s probably better to pay that card off.
Is it good or bad debt?
While you might think debt is debt, there is a difference. Good debt is money borrowed at a low interest rate that allows you to make a high rate of return. Say, you borrow to buy an apartment complex, that debt is covered by the rental income you’ll bring in, at least within a few years anyway.
Bad debt refers to consumer debt, meaning money borrowed at high-interests rates for things that aren’t going to produce income or increase in value, such as clothing, cars and travel.
Earning a higher return on the investment than the interest you’re paying usually means invest
The bottom line is that if you’re able to earn a higher return on an investment than the interest you’re paying on your debt, the answer is to invest. This is a strategy Warren Buffet used, to illustrate. He purposely carried a mortgage on his Omaha, Nebraska home for some time as he need he’d be able to make his money work better elsewhere, in his investment portfolio. Looking at your situation if you’ve purchased one of the houses for sale in Phoenix and are carrying a mortgage, it may make better sense to invest that inheritance than to pay your mortgage off if you can earn more interest than you’re paying out on that home.
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