You’ve been doing everything right.
You’ve kept your expenses low and managed to save away some money.
Your once mounting debt is slowly shrinking.
The balance of your savings account has finally reached a point where you could wipe it out forever. No more debt! Poof. Gone.
All it would take was one transfer and you would never have to deal with it again.
But there’s this little niggle in the back of your mind. You already had a plan to pay off the debt and it’s working. Why would you deviate now? It’d be nice to have it all paid off. But you can’t shake the thought that you might be able to do more useful things with the money.
You could finally start building that investment portfolio you’ve always dreamed about.
But should you?
It can be tempting to quickly wipe off your debt. You’d be free of it forever.
Stepping back and considering these questions before you make your choice can help make the decision a little bit easier.
Can I afford to lose this money?
Obviously you don’t want to lose money but that’s not really the question.
The question here is can you afford to lose it?
All investments have a risk/return tradeoff. Ultimately the higher risk the greater your potential return.
Paying off the debt is almost a sure thing. The risk is lower and the payoff is almost guaranteed. If you pay off your debt, it’s gone. There are no more payments to make and no further interest will accrue.
There is increased risk if you do decide to invest, though.
Ask yourself if you can afford to lose 5%, 10% or 20%. Whilst I’m not saying this will definitely happen, it could, and you should be prepared if it does.
Can I afford to not pay off this debt?
What will happen if at the end of the day you can’t pay off your debt? Will there be a couple of burly men knocking at your door?
If you can’t afford to not pay your debt, then pay it.
There’s no point risking your credit rating, tarnishing your credit report or facing the burly men when you have the opportunity to pay it off.
There’s probably no worse feeling than knowing you had the opportunity to get yourself out of a particular situation but instead you chose to do something else.
What type of debt do I have?
This is probably one of the most important questions.
Is your debt, good or bad?
The use of debt to purchase assets can help amplify your returns. But it’s a double-edged sword. Debt can quickly become a large headache when used to purchase liabilities.
Good debt allows you to apply leverage to a situation in order to maximise your return on investment.
This could be the use of a mortgage to fund the purchase of an investment property or a margin loan to purchase shares. Just remember good debt = used for assets. Good debt is useful as long as you’re able to meet the loan repayments on a month to month basis. As long as the good debt is still serviceable you generally don’t need to pay it off early.
Now, the other edge of the sword. Bad debt.
Bad debt is the use of leverage to fund the purchase of liabilities.
If you’ve accumulated high-interest rate debt on liabilities e.g. luxury purchases on a credit card. Then it might be a good idea to pay these down first.
Bad debts can mount up quite quickly if not kept in check. The longer you put it off. The larger the debt becomes. This is a massive issue because there is no underlying asset.
What do I expect to earn from my investment?
Whilst historical performance isn’t exactly indicative of future performance; you should still be looking at how a particular investment has performed.
If you’re investing in a fund, do your research.
If you’re buying stocks, do you research. A little analysis can go a long way.
If the investment you’re considering is a little more alternative, consider a basic risk-adjusted return calculation.
Work out whatever your range of possible returns and multiply it by the likelihood of achieving the return. For example, say you could invest in your brother’s dry cleaning business.
There was a 50/50 chance that you could earn 15% return on your money or lose it all. If you multiply the probability of each outcome by the expected return (50% x 15% + 40% x 0%) your risk-adjusted return is 7.5%.
Considering how much you can realistically make on your investment vs. how much you’re likely to save on your debt can put things in perspective. If you’re going to make $1,000 a year on your investment but are paying $2,000 a year in interest on your debt. Paying down your debt might be the way to go.
How much disposable income do I have?
How much money do you have left at the end of each month? Can you afford to redirect some into investments?
If you have sufficient recurring disposable income then the risk associated with investing is reduced.
It also means that you’re more able to keep servicing your debt, i.e. you have enough money to keep paying off you debt. If you current payment strategy is working then you might be able to take some risk and start investing.
How will I feel if I…?
Mentality can play a large role when deciding whether or not to pay off your debt or invest.
Whilst money management can often seem to be a black and white school of thought.
There is always emotion attached.
We are human after all.
In addition to the questions above consider these.
- How will I feel if I haven’t paid off my debt and my investments perform well?
- How will I feel if I haven’t paid off my debt and my investments go bad?
- How will I feel if I pay off my debt and the potential investment goes well?
- How will I feel if I pay off my debt and the potential investment goes bad?
If you can’t actually fathom having debt or if it will haunt you in your dreams. It might be time to wipe it out.
So are you ready to make a decision?
Whether you end up choosing to pay off your debt or invest, taking some time to carefully consider your options will help to remove some of the uncertainty from the process.
Either option is going to benefit your finances. You just need to make sure that the option you choose is the one that’s right for you.