If you find yourself in the enviable position of having extra cash on hand, is it better to invest it or to use it to pay down debt? There isn’t a one-size-fits-all answer, and the best choice for you depends on a number of factors.
4 questions to ask when deciding whether to invest money or pay off debt
What is your debt’s APR?
If the debt you’re carrying has a high APR, as is often the case with credit card debt, then the decision to invest or pay is fairly simple. The average credit card APR is close to 17%, so paying off this type of debt first before you think about investing could save you thousands of dollars in interest.
What’s the expected return on your investment?
You should consider the return on your investment. If your expected return is more than the debt’s interest rate, you may want to invest instead of putting the extra cash towards debt.
What type of debt are you carrying?
Not all debt is created equal. Another consideration is whether there are tax benefits to your debt. You should consider the type of debt you’re carrying, the tax implications, and your income when deciding to invest vs. pay debt.
For example, depending on your income, student loans can offer tax incentives that can help alleviate the burden of carrying it as debt. If your modified adjusted gross income is less than $85,000 per year as a single filer or $170,000 per year as a joint filer, then you might qualify to deduct up to $2,500 from your taxes. In this case, you’re incentivized to pay your loans for the tax deduction benefit.
How risk averse are you?
You should also take your emotions and tolerance for risk into account. If you’re naturally risk-averse and carrying debt affects your peace of mind, you may want to prioritize paying down debt over investing.
How to pay down debt
If you decide it’s in your best interest to pay down your debt first, two great repayment options are the debt snowball or debt avalanche methods.
- Debt snowball: The debt snowball method involves paying off your debts in the order of smallest to largest, regardless of the interest rate. You’ll pay the minimum amount on all your debts but put extra money towards the smallest debt. Once that’s paid off, you’ll pay off the next largest debt.
- Debt avalanche: With the debt avalanche method, you’ll pay your debt off in order of highest to lowest interest rate. You’ll make minimum payments on all your debts, but prioritize paying off the one with the highest interest rate first. Once that’s paid off, you’ll pay off the debt with the second highest interest rate, and so on.
