Tough decisions
It’s a common dilemma: You have to pay off debt, but you also want to make headway with your investing goals. Which should come first? You’ll win either way, so your decision is really about how to win faster. Here is some advice from financial experts to help you formulate a strategy.
Compound interest vs. a healthy credit score
If you pay off debt first, you will lose the power of compound interest on the investments you could have made with that money. But if you invest first, you will be stuck with managing the debt, paying high interest rates and making sure you don’t invoke unintended consequences, such as undermining your credit score by only paying the minimum balances.
Triage your debt.
Organize consumer debt accounts according to their interest rates so you can see which are costing you the most, says Paul Heising, a financial advisor with Smarter Decisions, an investment management firm based in Torrance, California. Pay back loans with the highest interest rates first, especially if those rates are over 10 percent annually, he says. If you have multiple consumer loans, double down on one with a low balance so you can get an early win by closing it out.
Student debt is a special case.
Lance Riddle, a principal with OptimalFolios, a financial planning firm in Dallas, says student debt is more insidious for people nearing retirement. He often advises those in their 20s to start investing before paying off their low-interest student debt, but he recommends the opposite for parents and grandparents who have taken out education loans for their children and grandchildren. “Wipe that [debt] out,” he says.
Take advantage of your 401(k).
Meanwhile, gain traction with investing through your 401(k) plan at work. Set aside the maximum to win the employer match, even if that means it takes a little longer to pay down your debt. “If you don’t take advantage of the match, you are losing the advantage of time,” says Brad Duerson, professor of personal finance and economics at Des Moines Area Community College in Iowa.
When will you see progress?
How much of a difference will it make if you pay off your debt early? Explore the “what if” scenarios with this Bankrate.com calculator. You can play with both the amount you pay monthly and the time frame to see what it would take to pay off a card balance early. Line up both the interest rate on your debts and the expected return on your investments with this CalcXML calculator.
Know your tipping point.
How much consumer debt is too much? “The tipping point is different for each individual,” Heising says. He advises clients with high levels of debt to add up not what they owe, but the total interest they are paying on consumer debt each year. “When I show a client the total interest alone on their credit cards, of say $5,000, that’s over $400 a month just to maintain the debt,” Heising says.
Make it real.
Compare the amount you pay in debt interest alone each month with the amount you spend on another household finance category, such as food, clothes or entertainment. This exercise shows what you could buy with just the interest you are shelling out, Heising says. For many people, this comparison converts the fuzzy debt problem to real things they don’t have — and it can be highly motivating, he says.
How much is too much?
Individual tolerances vary, Heising says, but it helps to think like a lender. It’s not how much you owe in total that causes a problem — it’s how much consumer debt you owe compared with your total credit limit. He advises adding up the total amount of debt on consumer accounts, then comparing that with the total credit limit on those accounts. If you owe upward of a third of the total credit limit, your credit score is probably suffering.
Bonus: Either way, you will build good financial habits.
Duerson points out that paying off debt is satisfying on its own. Once you’ve paid off those accounts, continue setting aside the same amount each month — but for investing instead of debt repayment. Establishing an automatic savings habit is one of the most difficult and important tactics to building wealth — and you’ll have done it.
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Should You Invest or Pay Off Debt? originally appeared on usnews.com
