Should You Invest Or Pay Off Debt First?
Consumers are told that investing is a great tool to secure your future finances. However, what if you are currently in debt? Should you pay off your debt first or start investing now?
Investments need time to mature and bear fruit. If you start too late, your returns could be abysmal. However, if you start early, while you are still in debt, there's a good possibility that you could lose your investment money to a lender. Herein lies the dilemma of investments versus debt.
If you dedicate your life to paying down debt, you lose opportunities to increase your overall wealth. Not paying down debt is also not healthy for your financial life.
There are, however, certain ways to determine if you should be investing, paying off debt or both. Here are some of those ways:
Calculate Your Income-to-Debt Ratio
A debt-to-income ratio, or DTI, is a simple measurement that showcases your ability to repay monthly loan bills and also cover everyday expenses. It's easy to calculate: Simply sum up the total amount you owe each monthly for all loans, and divide that amount by your income. The number you get is called the DTI. The higher the DTI is, the more you are in debt. Ideally, your DTI should be in the 25 to 33 percent range. The higher your DTI, the more in debt you are.
Generally speaking, if your DTI is 30 percent or lower, you are in good shape to invest. If your DTI is over 60 percent, you should definitely pay off the debt first. If your DTI falls in the mid-range, close to 40 percent, you can still invest, but only if the investments are less risky and come with high returns. Here is the handy tool to calculate your DTI.
Consider the Interest Rate on Debts
If you have accumulated debt thanks to loans with sky-high interest rates, these should be paid off first. Credit card debt is a prime example. Credit cards usually charge holders close to 40 in annual interest rate. A good majority of investments do not offer returns high enough to match this rate. So, even if you make money with investments, you are losing all that money right away to credit card debt. Personal loans, too, can have this effect.
Therefore, compare the interest rate on the debt with the interest on an investment. Unless the debts have a significantly lower interest rate than potential investments, do not use your money to invest. Do the math and pay off all high-interest generating loans. You do not want to lose your returns to these interest rates.
Evaluate the Risk of Investments
All investments are risky, but some carry more risk than others. For example, investing in the stock market may generate higher returns than buying a government bond, but is highly risky. You should never take on risky investments when you are in debt. You risk losing it all when you do so. Even if the potential returns are high, the risk is never worth it when it comes to investing while in debt.
Your age, earning power and tax situation can elevate your risk for investments as well. For example, if you are older, you might be able to make back the money you may lose with an investment. Therefore, the older you are, the riskier your investments become. It's good be debt free or almost debt free when you are over 40.
You Must Have Enough Disposable Income
First of all, your regular income must be more than enough to cover your everyday investments. You cannot, and should not, invest if your debt has become too problematic and is straining your disposable income. Before you invest, you must also have an emergency cash reservoir for at least six months. When you are in debt, that kind of money is hard to come by. Therefore, if your income is not sufficient, and you are already in debt, you are better off paying the debt rather than betting your hard-earned money on an investment. Learn more about disposable income here.
Are You about to Default on a Debt?
If you are managing investments with debt, it's very important to keep track of your debts. If you miss payments or are about to default on a debt, you really should not be investing. If you default, you could lose an asset, or the creditor could sue you in court and claim your investment as repayment. So, manage your due payments well before you invest.
In general, if you have sufficient income, and are currently managing existing loan payments well, it may not hurt to invest a bit. However, you must make it a priority to pay off short-term loans. It's okay to invest with a mortgage if you have the money. Mortgages, after all, take decades to pay off. However, if you have a credit card debt due in 6 months, you must dedicate all your financial resources to paying off that high interest-generating debt, nothing else.