Should You Pay Down Debt or Invest?
You’ve found yourself with a lump sum of inherited or freed-up cash. Should you use the money to pay down your debt or should you invest it? There is no best option for all. It depends on your personal financial circumstances. This article helps guide you through your decision-making journey.
Understand Your Current Financial Position
If you do not already have a comprehensive financial plan then you may wish to establish one—ideally with the guidance of a financial professional.
Without a firm understanding of your current financial circumstances and a documented plan to obtain your future financial objectives, you are not ready to decide between paying down debt and investing.
Do You Have an Emergency Fund?
If you do not have an emergency fund then you may wish to establish one before you pay down debt or invest. An emergency fund provides a financial buffer for adverse financial surprises and helps to avoid increasing your debt burden.
Typically, such a fund should cover at least three to six months of living expenses in cash savings or very short-term, highly liquid investments.
It should be noted that credit cards are not an emergency fund—a credit card balance simply puts you further in debt!
Clarification of Your Debt
Good debt, bad debt, high-interest debt, low-interest debt, credit score and years to retirement are all factors that you may wish to clarify to enable you to understand your personal debt profile.
Debt may be considered good if it was incurred to purchase an appreciating asset, such as a mortgage on real estate. Bad debt is incurred when money is borrowed to purchase a depreciating asset such as a car or to cover an expense as in the case of credit card debt.
If your debt carries a low interest rate then you may be more confident of earning a higher rate of income through investing than the interest you have to pay on your debt.
High interest debt should usually be paid down before considering investing, particularly since the debt interest rate is a sure thing while investment market returns are uncertain and may even be negative in the short term.
If you have a low credit score or a high credit utilization ratio (over 30% of your available credit), then you may be wise to pay down your debt to improve your credit score. A low credit score will increase your cost of debt going forward.
Understand how you reached your current debt position. Do you have multiple loans, or a second mortgage? Do you have a habit of overspending? Do you have cycles of bad debt? Do you adhere to a budget? Answering these questions may help you to avoid increasing your debt unnecessarily.
Are you nearing retirement? It is best to begin retirement with as little debt as possible, as most likely, your monthly income will decrease. Reducing monthly expenses is an important part of retirement planning.
Keep in mind that the requirement to eventually pay off debt is certain, but investment returns are not.
As well, paying down debt also frees up future cash flow which can be used to further pay down debt or to invest as your debt reaches lower levels.
Paying down debt is the way to go if, after thoroughly examining all of your choices, your decision is still not clear.
Understand the Decision to Invest
Compared to paying down debt, the decision to invest is more complicated. Since you know the interest rate on the debt, the cost of debt repayment is a sure thing.
For most investments, the rate of return is relative to the amount of risk you are willing to take. In some cases the investment could also incur a loss resulting in a negative return.
Know your risk tolerance. If you have a low risk tolerance, for instance only being willing to invest in low return/low risk vehicles such as GICs or fixed-income securities, then it makes more sense to pay down debt.
If you are willing to take some risk and invest with the hopes of achieving a better return, you should feel free to invest—as long as you can continue to manage your debts.
The longer you invest in the market the more you can benefit from compounding and “time in the market” —earning future returns not only on your initial investment but on the growth of that investment to date.
Do Both—Pay Down Debt and Invest, If You Can
Sometimes a balanced approach may be best. It can serve both today’s needs and tomorrow’s goals: paying off some debt today while simultaneously investing for the future.
Both your investments and your debt are elements of your net worth. While your assets increase your net worth, debts drag it down. Since your focus should be on increasing your net worth, you should aim to increase your assets and minimize your debt at the same time.
To do this, commit as much of your cash flow to fulfilling these goals as possible—ideally, all of your free cash flow after you factor in your necessary expenses.
If you are going to invest and pay debt simultaneously, ensure that you are making the required minimum debt payments to avoid penalties, and that your investment return relative to debt interest is in your favour. This requires constant monitoring.
- Investing and paying down debt are both good uses for any spare cash you might have.
- Investing makes sense if you can earn more on your investments than your debts are costing you in terms of interest.
- Paying off high-interest debt is likely to provide a better return on your money than almost any investment.
- If you decide to pay down debt, start with your debts with the highest interest rates and work down from there.
- Always begin with an emergency fund if you do not already have one.
At the end of the day, the decision of whether to invest or pay down debt is a personal one and may be more complex than it initially appears. You may wish to explore how you can use the same lump sum amount of cash to be in a better financial position in the long-term through investing rather than debt repayment, and also how you can divide the lump sum of cash to both pay down debt and invest.
Your starting point may be to reach out to a trusted financial professional such as Bloom Investment Counsel, Inc. for help. Established in 1985, Bloom has experience in managing in excess of $2.5B in assets over the years for wealthy individuals, family offices, foundations, corporations, institutions and trusts.
This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.