Should I Invest or Pay Down Debt
If you have debt – whether, it’s credit card debt, mortgage debt or student loans – it may not make sense for you to own bonds, or, to invest at all.
Before learning how to buy shares in the stock market, it should go without saying that if you can’t make the minimum payments on your debts, you should not be investing at all. But if you have extra money left over from each paycheck, you have a few choices that can each have a positive impact on your finances:
1.) Use all of your extra money to pay down debts (mortgage, credit card, student loans).
If you have interest payments that are higher than 10%, you are almost certainly better off paying down debt than investing. The stock market has returned about 11% per year in the long-term (far less if you consider taxes and fees), but there are no guarantees in stock investing. Your debt, however, is guaranteed – sometimes, even after bankruptcy.
2.) Use all of your extra money to buy investments (stocks, bonds, funds).
This only makes sense if your debts aren’t costing you much, in other words, if the interest rate that you’re paying is low. If your debts are costing less than 5% interest, you may be better served (in the long-term) by investing your extra money in carefully chosen stocks or stock funds. If your mortgage is costing you 5%, it makes no sense to buy a bond or bond fund that yields 2%. A bond that pays you less in interest than the interest payments on your debt is not worth buying. And even if a bond pays you higher interest than what you owe, that doesn’t mean it’s always a good investment.
3.) Use some of your extra money to buy investments and some to pay down debts.
Benjamin Graham– Warren Buffett’s teacher – once suggested that investors should hold no more than 75% of their investment money in a single asset class (he was referring to stocks vs. bonds). You can apply this same logic when deciding how much of your extra money should be used to make investments.
If you treat your low-interest debt like a bond, then, at minimum, you’d use 25% of your extra income to pay this debt off – the remainder could be invested in stocks. If stocks or stock funds became too expensive (remember, the higher the stock market climbs, the more expensive it becomes), then you could use as much as 75% of your extra income to retire debt and the remaining 25% to buy stocks, despite their high prices.
Ultimately, you should pay down your debts with the highest interest rates first. For more complicated situations, it may be best to consult a fee-only financial adviser who is familiar with your situation. A financial planner is only as good as the information that he or she is provided with, so if you consult an adviser, be sure to mention all of your debts as well as your investments and investment ideas.