To Invest or to Pay Down Debt: That is the Question
When you have excess cash flow there are 3 things that you can do with it:
- Save it
- Pay down debt
- Spend it
There is only one “bad” option out of those, and it is number 3. Whether you save it or use the excess money to pay down debt, both will help you in the long run. So which one should you prioritize?
If you do choose to save the money, this was a good choice! If you are saving it in the bank, it might make a couple tenths of a percent in interest if you are lucky, but this rate of return is guaranteed. However, if you choose to put that money into an investment account, you have the potential to make a much better return on your money. For example, the S&P 500 has had an average return of about 8% since it began tracking 500 companies like it does today. This is obviously a much better return than just leaving it in the bank, although this return is not a guarantee like the bank might be. If there is one thing we are sure of in the stock market, it is that you will never get a steady, guaranteed, rate of return. The market will have bad years where you may lose money, but it will always have good years where it performs above the 8% average. That is how we arrive at the 8% average anyway.
Pay Down Debt
If you go with option number 2 and use it to pay down debt, this is also a good option! When you are being charged a rate of interest on a loan that you have then you are essentially giving away that percentage of your money. Now, getting a loan isn’t a bad thing as it can be used to purchase very valuable assets such as a house. However, we must understand the costs of the loan which is the interest rate. If you use your excess cash flow to pay down the debt more quickly than you were planning on, then you can consider that you are “saving” the interest rate. So if you have a 4% loan, and you put an extra $1,000 towards the loan, then theoretically you are getting a 4% rate of return on your money because that is less interest that you will be charged. In today’s environment you will almost certainly not have a loan at 8% or above like the S&P’s historical return, however using money to pay down this debt is a GUARANTEED rate of return. The only risk in using money to pay down debt is the opportunity cost that it is a great year for investments and you could have made more in the stock market.
Which One is Best for Me?
The answer is actually pretty simple. The best option for you is the one that resonates the most with you. Do you like to go with the numbers and invest the money because you know long-term the S&P will likely produce a better return than the interest rate on your loan? If so, then investing the money is probably best for you. Do you prefer to know that you are cutting down on your liabilities so that you do not owe anyone any money? If so, then paying down your debt is probably the best option for you. Both of these two options are good ones, so do not be afraid that you are making the “wrong” choice.
In conclusion, as long as you are doing something productive with your money by either saving it or using it to pay down debt then you are making a smart choice. Choosing which of these two options to do is a matter of which one resonates the most with you, and which one will make you feel the best emotionally.
If you would like to have a discussion on your financial situation and want to learn more about how Peak Wealth Management can help you achieve your goals, please give us a call at (734) 681-7575 or email me directly at email@example.com