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If you have some extra cash flow each month, you may be wondering what's best to do with it: pay off debt or invest it?
The answer can be complex, and it varies depending on your financial situation. So it's important to consider where you're at financially, the rates of return you could expect with each option and more. Here are some steps you can take to make the right decision for you.
Assess Your Financial Baseline
Before you start putting your money toward either option, it's essential to make sure you have your financial basics covered. The best way to do that is to create a budget if you don't already have one so you can see how your monthly income is used.
Some experts recommend using a 50/30/20 approach to your budget: 50% of your income goes toward necessities (food, shelter, utilities and so on), 30% toward discretionary spending (optional expenses) and 20% toward savings and debt payments.
That's just a starting point, however: Depending on your situation, you may need to reduce your discretionary spending to focus on eliminating debt or saving for the future. It's important to consider your situation and goals to find the right balance.
Once you determine the amount you're able to set aside for paying off debt or investing, you need to prioritize your options. As you think about the best strategy, consider these basics first:
An emergency fund is crucial to helping you get through challenging financial times with as little impact on your financial well-being as possible.
Whether it's due to a job loss, a medical emergency or needed repairs on your car or home, having cash for a rainy day can make a world of difference. Experts generally recommend having three to six months' worth of expenses set aside in an emergency fund.
For some people, though, it can take years to accumulate enough cash to achieve that goal, so consider starting with at least $1,000 or $2,000 as a small buffer, then continue to build your safety net while working toward other financial goals as well.
401(k) Contribution Match
If your employer offers a 401(k), it may match some or all of your monthly contribution to the retirement account. For example, a common match percentage employers use is 3%. So if you contribute 3% of your annual salary to your 401(k) account, your employer will chip in the same amount, effectively boosting your savings rate to 6% a year.
Taking advantage of a 401(k) contribution match is important regardless of your debt situation because it essentially provides you with a rate of return of up to 100%—if you put in $100 per month and your employer puts in another $100, you're doubling your investment automatically. It also reduces your taxable income and, most important, is one of the easiest ways to prepare for retirement.
High interest debt can be expensive, but past-due balances can affect your credit and financial well-being for years. If you're delinquent on any of your debts or you have accounts in collection, work on paying those off before you take any other steps to invest or pay off other debts.
Delinquencies and collection accounts can hurt your credit as long as they remain on your credit report. The faster you can get current, the better.
Look at Debt APR vs. Your Investment's Expected Return
Once you have your basic needs taken care of, the easiest way to decide whether you should pay off debt or invest is to look at the interest associated with both choices.
If you know the rate your investment portfolio—or an investment such as a mutual fund or stock you're considering if you don't already have a portfolio—earns, use it as a benchmark to determine which debts to pay off before you invest.
Say your portfolio yield is 7.5%. If you have credit card debt at a 17% interest rate, you'd effectively be earning 17% in the form of interest savings when you eliminate that debt. On the flip side, if your only debt is an auto loan that charges a 3.5% annual percentage rate (APR), you'll earn more by investing your extra cash than by using it to pay down the car loan more quickly.
Debts such as payday loans, auto title loans and personal loans with repayment terms of less than one year generally charge very high interest rates, and thus paying them down should almost always take priority over investing.
In some cases, you may see an interest rate instead of an APR—the two are not the same. While an interest rate represents how much interest the lender is charging you to borrow money, the APR represents the full cost of financing, including fees and other charges. Use an online APR calculator to find out what you can expect to pay on your debt.
How to Pay Off Debt
As you work to pay off high interest debt, here are some tips to help you achieve your goal more quickly:
Check Your Credit Report
Before you start paying down debt, take a look at your credit reports to get a comprehensive view of all your debt accounts in one place. Checking your credit will help you understand the balances of your loans and credit cards, your credit limits, and any accounts you may be behind payments on.
If you have accounts in collections or credit cards you're close to maxing out, those accounts may become your priority when paying down your debt. You can get a free copy of your credit report through AnnualCreditReport.com or through Experian.
Decide How Much You Can Pay
Take a look at your budget and determine how much of your monthly income you can use to pay down debt. Be realistic about your capacity and make sure to give yourself a buffer so you don't overextend yourself.
See if You Can Reduce Your Rates
Depending on your situation, you may have some opportunities to score a lower interest rate on some of your debt. With credit cards, for instance, you can call and request a lower rate—there's no guarantee you'll get one, but it doesn't hurt to ask. You can also use a debt consolidation loan and replace some debt with a loan that carries a lower interest rate.
Use the Debt Avalanche Approach
It goes without saying that you should make at least all of your minimum monthly payments on time to avoid late fees and damage to your credit. To accelerate your debt payoff, consider the debt avalanche strategy, especially for revolving debt such as credit cards.
With this method, you'll take stock of your current debt situation by listing each card account, along with its balance and APR. Then you'll focus on tackling the account with the highest interest rate first.
Make minimum payments on all your debt except debt with the highest interest rate first, which you'll pay the minimum on plus as much as you can spare in your budget. Once it's paid off, you'll apply that amount to the regular payment you were already making on the debt with the next-highest interest rate. Continue this process until your debts are paid off.
Be Diligent About Avoiding High Interest Debt in the Future
Paying off debt is an essential step in improving your financial situation, but it may not solve the root problems that led to the debt in the first place.
If you racked up debt because of overspending, it's important to take steps to avoid ending up back where you started. You may, for example, consider switching from credit cards to debit cards. It's also important to get on a budget and track your spending every month. Do whatever you need to in order to avoid high interest debt going forward.
How to Start Investing
If you don't have any high interest debt, investing your extra cash flow can help you create a better life in the future.
In general, the best place to start with investing is your retirement account. Experts at Fidelity Investments recommend putting at least 15% of your annual income toward retirement. Whether you do that through a work-sponsored retirement plan or an individual retirement account (IRA) is up to you, but make sure you're never leaving any money on the table, such as from an untapped employer match to your 401(k).
Beyond retirement, the right investments for you will depend on your risk tolerance. Risk tolerance is a term used to describe your ability to withstand a certain degree of volatility in your investments.
For example, stocks are generally riskier than bonds, and mutual funds can help provide diversification among stocks, bonds and other investments to reduce the risk from each one individually.
Factors that help determine your risk tolerance include your age, income, lifestyle and when you'll need the money.
Someone who is 30 years away from retirement may have no problems with an aggressive stock portfolio, because their long-term investment can weather the ups and downs of the stock market. If you're two years from retirement, however, a market downturn could wipe out a significant chunk of your investment right when you need it for living expenses. In that case, you might have a lower risk tolerance.
It Doesn't Have to Be All or Nothing
As you approach saving, investing and paying off debt, keep in mind that you don't have to focus on just one thing at a time. If you do, it could end up taking longer to start working on each of your goals, which could delay your success.
Look to find a balance between your savings, investing and debt payoff plans. While it can take a little longer to achieve each goal this way, it can give you a more well-rounded financial foundation and pay off in the long run.
Also, it's important to keep your emotional needs during this process. For example, if you're experiencing significant stress over your low interest car loan, the peace of mind that comes from paying it off may be more worth it to you than your investment returns.
Finally, keep in mind that investing doesn't come with guaranteed growth. Any average or likely rates of return you may see are often based on long-term performance, and you may experience higher highs and lower lows—even negative growth—in the short term.
As you try to find the right strategy for you, it may be worth working with a financial advisor, who can not only provide valuable advice about what to do with your money but can help you find good investment options if you choose to take that route.