Is It Better to Pay Off Debts or Invest?

Almost everyone has some sort of debt and economic data shows that this is the case. Between mortgages, student loans, credit cards, business debts, and auto loans and leases (yes, a car lease is debt), many people find themselves allocating large portions of their income towards debt payments. When you are in a position to start paying off debts, should you do so or invest your extra funds? Let’s take a look at the pros and cons of each.

Pay off debts: Pros: Paying off debts with your extra cash will help you to decrease your liabilities, save interest, which can be significant with credit card debts and some business loans, and eventually enable you to free up cash flow. A non-conventional way to pay off debts is to start with the smallest balance debt to get the momentum going.  Cons: If you focus solely on paying off debts while ignoring investing then you will have no assets for long-term or short-term needs. If a short-term emergency arises, then you will be forced to incur debt to pay for it.

Invest your extra funds: Pros: Investing and savings will hopefully produce a much larger amount of assets over time and enable you to take care of emergencies that arise. Keep in mind that funds for emergencies should be kept very liquid, and a reasonable amount to set aside should be 3 to 6 months of expenses. Cons: Your liabilities will decrease slowly, interest expense will remain high, and you most likely will earn less on your investments especially when factoring in risk, then if you were to pay off debts.

Alternative: The decision to pay off debts or invest does not have to be an either or. Some well-known experts advocate at both ends of the spectrum. Why not do both? Assess your debts and savings to see where you will get the most bang for your buck. For example, let’s say you are able to allocate 6% of your income to savings or investments, then you can use 2% to pay off high interest debts, 2% to save for short term needs, and the remaining 2% can be used to save for retirement.

What if you don’t have extra funds?: The solution is simple, but not easy. Assess your lifestyle to see where you can cut expenses while working to increase your income. If you spend everything that you make currently and work to increase your income by 3% and decrease your expenses by 3% then you will now have extra funds. If your situation is more extreme, such as expenses that are higher than your income, then you will have to take stronger action. For smart ways to cut expenses, then type “expenses” in the search function of this blog.

The mature approach: If you have large excess funds then don’t incur more debts and pay off existing debts quicker once your savings rates are much greater than needed. You can be the only one on your block that doesn’t have debt and no one has to know. I am sure that the quality of your sleep will improve!

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