Your bonus is due and all you can think of is making the next investment move or topping up your existing investments. Behold! You also have lingering debts that you dare not ignore. Both paying off your debt and focusing on investments are equally important. Deciding between emptying the burden of accumulated debt versus putting in money in high-return investments can be tricky and involves consideration of numerous factors.
Debt Repayment versus Investing
Take, for example, you have a credit card debt riding on you at a 20 percent interest rate. If not paid in time, the compounding effect of the interest on the debt will cause it to grow each time. The same is with loans (home and personal). This means that your debt payments will increase with time. This explains why you must pay off your compounding debts quickly.
You cannot ignore investments too as parking money in an investment vehicle is an essential element of financial planning. Be it stocks, equities or debt bonds, investing money consistently will help your money to earn returns and grow in the long run. However, a lot depends on the interest you earn and whether the returns on our investments would be consistent corresponding to the interest that would accrue on your loans and liabilities.
Our investment choices are tied to our financial goals. This explains why most of us put our money in a host of options including shares, equity funds, balanced or hybrid mutual funds, debt instruments like bank deposits and money market instruments, etc. Simply speaking, you must check if you are earning more money on your investments than your debts that must be costing you.
For example, if you have taken a home loan with an interest rate of roughly eight per cent per year, your investments must earn at least 10 per cent interest so that you can use a part of the interest earned to repay your debt. However, credit card debts can be heavy to the tune of 20-40 per year. Unexpectedly, investments can be volatile. The returns on your investments may fluctuate depending on market movement or may not be enough to pay off your credit card debt that would build up month after month, if not paid.
Why repay your debt first?
The arguments in favor of debt repayment first far override the choice to invest money. This is because in most the debt interest rate is far higher and more consistent than returns on investments. This is especially true of credit card debt. The average interest rate on credit card debt is somewhere around 20 per cent. Very few investments fetch returns matching this level of debt.
Prioritizing debt repayment is also important to improve your credit score. Not many realize how important is this number to apply for further loans in the future, be it a home loan, car loan or personal loan. Suresh Sadagopan, Managing Director & Principal Officer, Ladder7 Wealth Planners says, “Non-payment or late repayment impacts the credit score negatively and the score goes down.
This would mean that getting a loan in the future may not be possible or even if one does get a loan, it will be at elevated interest rates.” Lenders either charge high or show less inclination to accept loan applications from interested borrowers with low credit scores.
“When a person has a low credit score, one may not be able to get an unsecured loan when needed. For people with a low score, they may ask for collateral. Also, the rate of interest will go up when the credit scores are low,” adds Sadagopan. Paying off your debt, especially the high-interest rates can be a good way to raise your credit score.
Doing both
It does not always have to pay off debt first and invest later. Instead of feeling frustrated with choosing between debt repayment and making investments, you can choose a middle way that allows you to do both, thus, allowing you to get rid of your financial liabilities while securing the necessary funds for future use.
Instead of using all the excess cash to repay your debt, you may set aside some of it to create an emergency fund, if you do not have any. If you already have an emergency fund in place, you may consider putting some money in it to replenish it regularly. You may either put your money in a recurring deposit or short-term fixed deposit or money market instruments that meet short-term requirements.
Though the thumb rule requires one to have six months’ worth of expenses saved in an emergency fund, you may limit the fund to three months’ worth of expenses, if you are struggling financially to repay your debts or if the debt amount is hauntingly huge. Though it may seem a tad difficult in the beginning, having an emergency fund to fall back on is better than not having any. Once you have lowered the debt burden, you may consider building up your savings to the desired level.
Focusing on debt repayment
How you repay your debt must rely on the nature of debt you have. You may have multiple loans riding on you, which means that you must play smart while repaying them. What payoff strategy would suit your best is a question that you must ask yourself before deciding which debt to repay first considering all your loan accounts would be of varying amounts and interest rates.
Simply put, you can start with the debt with the highest interest rate that will save you more money in the long run and allow you to redirect your remaining funds toward your other financial goals. However, if you have got a handsome bonus in hand or benefited from a windfall amount, you must pay off the debt with the highest balance first. A lot also depends on what kind of loan you want to apply for in the near future. In such a scenario, repay your credit card debt soon if you have one.
The essence of using money
Getting rid of all your debt won’t happen overnight, which means that you must adopt a persistent approach toward loan repayment, and subsequently, riddance. You may start with repaying the loan with the largest outstanding balance amount so that you get immense satisfaction from seeing much of your financial troubles being dissipated with time. The goal should be ultimate freedom from debt though securing some money to continue with your investments, if possible, is also advised.
If you ever find yourself in an enviable situation wherein you have some extra cash in hand, choose between debt repayment and investment wisely.