The Smartest Way to Balance Investing with Paying Off Debt – Ecologic America

The Smartest Way to Balance Investing with Paying Off Debt

Living a debt-free life isn’t immediately within reach for many people. For those working to lower balances on credit cards and paying extra each month to shrink their loan balances, it can be intimidating to throw a lot of money at debt while ignoring opportunities to invest.

Before considering the question of whether to pay down debt or invest, make sure you have these financial to-dos handled:

Arrange to have the minimum payments on every loan and revolving credit account handled automatically. Whether you use your bank’s bill pay system or set up automatic withdrawals through each account, you must make every payment on time to prevent damaging your credit. If you struggle with a low credit score, setting up automatic payments could help you repair the damage by establishing a solid payment history.

Establish a small emergency fund, separate from your everyday checking and savings accounts, to prevent using expensive credit to cover unexpected non-negotiable expenses. Many people find themselves deep in credit card debt or on the receiving end of a large and costly personal loan because they haven’t saved money over time for emergencies. If you don’t have a minimum of $500 to $1,000 set aside to handle life’s surprises, make sure you take care of that detail before you worry about whether to pay down debt or invest.

Create a budget that works for you and that you can stick with long-term. Your ability to design a budget that gives your income direction determines your likelihood of financial success in the long term. If you’ve failed at budgeting, you aren’t alone. You must start over and find a way to make a spending plan work in your life. Managing your money in the way that’s most natural for you could mean using a budgeting app or using a notebook, calculator, and pen. There’s no wrong way to create a budget.

Since the question of whether to save or invest is just as much about how the numbers add up as it is about how you think and feel about money, you must handle your budget, your emergency fund, and your minimum debt repayments before addressing this problem. After you’ve taken care of these three basic financial housekeeping chores, you can make decisions about how to spend your excess cash.

Consider your income source when building your emergency fund

There isn’t a one-size-fits-all answer to questions about the size of your emergency fund. If you are living on a single income and you work for a startup, it’s smart to build up a considerable amount of savings so you can remain financially stable if you need to look for new employment. Anyone who is self-employed should aim for a savings account balance that could handle six months of living expenses. Not only will this see you through times when work is sparse, but it will also give you some leeway if you want to change direction with your company.

Think about your personal preferences regarding debt vs. investing

It’s a good idea to learn as much as possible about how to evaluate your debt and weigh the importance of paying it off against the need to save money and invest it for the future. Even so, if you have strong feelings about paying off debt or adding to your savings and investment accounts, you should do what seems right for your situation.

If your preferences don’t compromise your ability to pay your bills, put your family at risk, or wreck your credit, you’ll be happiest if your plan meets your psychological needs as you move toward achieving your goals.

High-interest debt vs. traditional retirement accounts

For a two-earner family with an annual income of $50,000, saving is crucial. Emergencies happen to everyone, and relying on credit isn’t the ideal way to handle life’s surprises. But when debt piles up and credit card interest rates hover near 20%, paying off those balances becomes more important than investing money in retirement accounts.

If there’s an opportunity to capture an employer match, it’s crucial to take advantage of that benefit. So, in this example, one spouse may have an employer willing to match 50% of their 401(k) contribution, up to 3%.

Gross income: $30,000

Employee 401(k) contribution: $900 per year

Employer match: $450 per year

So, for $900 per year, this person receives a pre-tax $1,350 contribution to their retirement account.

The other spouse doesn’t have an employer match. The couple owes over $10,000 on three credit cards at 20% interest, so they decide to dedicate all their disposable income to pay off that debt. They’ll make $400 payments on the debt and have it taken care of in 33 months.

While it may be uncomfortable to refrain from putting money into investments during this time, since they know they won’t make a 20% return, it makes sense to concentrate on paying off their high-interest debt.

After eliminating their credit card balances, they can turn their attention to building savings and investing with the intention of letting their money grow.

Low-interest debt vs. high-interest debt vs. investing

An individual that wants to pay off their mortgage within ten years and has credit card debt should prioritize paying off the higher-interest obligation before turning their attention to paying off the mortgage and investing.

For example, an individual with an $83,000 annual income, and $21,000 in credit card debt at 10% interest and a $340,000 mortgage at 3.8% interest would be better off paying the credit card debt as quickly as possible and then maximizing their pre-tax retirement account contributions.

The interest rate on the mortgage is much lower than the average rate of return on many 401(k) accounts, so it’s important to take advantage of the tax benefits of contributing the maximum allowable amount to that account.

Mortgage interest is also tax deductible, so eliminating a home loan before investing in accounts that are likely to get more than a 3.8% return may not be the best use of this person’s $83,000 yearly income.

What to do if you are living paycheck-to-paycheck

If you have very little money left over after paying bills to invest or pay down debt, it’s nearly impossible to improve your financial life without cutting expenses. 75% of Americans live paycheck-to-paycheck1, so don’t consider yourself a failure if you are among them.

If your employer offers to match a portion of your 401(k) contributions, take advantage of that benefit. Not doing so means leaving behind a bonus that could help secure your financial future. With that small automatic investment in place, you can turn your full attention to paying off debt as quickly as possible.

If trimming your expenses to free up cash for this purpose isn’t an option, shift your focus to increase your income. Here are some ideas to get you started:

If you have a newer vehicle, clean driving record, and live in a large town or city, driving for Uber or Lyft could offer you a nearly immediate source of extra cash. Check with your insurance company to find out if this side gig will cause a rate increase before you start, though.

There are plenty of places online for someone with professional skills to make extra money. Check out Fiverr to see if there’s a niche that’s perfect for your skill set. Graphic designers, web designers, SEO professionals, IT experts, accountants, and digital marketing gurus can use this platform to find out if this type of side gig is a good fit. For credentialed professionals, Just Answer may offer a good source of extra income, as well.

Most people have too much stuff. If you feel like you could unload some of your things for cash, here are the best places to do so online:

  • Used smartphones: Gazelle
  • Name-brand clothing, shoes, and accessories: Mercari, Poshmark
  • Arts, crafts, and vintage household goods: Etsy
  • Textbooks, movies, other books: Amazon
  • Furniture and larger household goods: Craigslist, Facebook Marketplace

When evaluating possible side hustles, consider whether it may be a better use of your time to take on a part-time job. Even delivering pizzas for a few hours every weekend could add $200 per month to your income. Spending the same amount of time trying to make money on an online survey site isn’t nearly as profitable for most people.

Paying off debt helps your credit score

If you have credit problems, one way to help boost your FICO score and clean up your credit report is to pay off debt. Not only does it protect your future income from going toward interest payments, but it also lowers your total credit utilization when you pay down revolving charge accounts like store-branded cards and credit cards.

So, if you owe $5,000 on a credit card with a $10,000 credit limit, your credit utilization ratio for that card is 50%. Your credit utilization ratio makes up about 30% of your FICO credit score. Ideally, you’ll keep your balances on credit cards below 25% of the available credit limit. If yours are higher, paying the balances down will help raise your credit score.

Having a healthy credit score could save you money on utility deposits, earn you a lower interest rate on auto loans and your mortgage, and save you money on car insurance. So, paying off debt doesn’t just free you from monthly payments. It makes room in your budget for investing as your interest rates, fees, and insurance premiums decrease, as well.

One area where your credit score has a measurable effect on your ability to save money is your home loan. If you spend $200,000 on a home with a $40,000 downpayment and your credit score is above 740, you could easily get a 30-year mortgage with a 4.25% interest rate. Your monthly principal and interest payment would be $787. If your credit score was 680 in this scenario, your interest rate would be 4.75% with an $834 monthly payment. You’ll pay $16,920 more for the same house because of a 60-point difference in your FICO score.

If you make a monthly deposit of the $47 difference between the higher and the lower mortgage payments into a high-yield savings account with a 3% rate of return, you’d have $27,391.09 built up by the time you paid off your home.

Your FICO score has a significant effect on the amount of money you pay for access to credit and insurance. Even if you decide not to use credit cards or borrow money, taking care of your credit score is crucial to your ability to save as much money as possible.

Consult the experts

If you have specific questions about the tax implications of paying off a mortgage ahead of schedule or contributing to a retirement account pre-tax, it’s best to consult a certified tax planner or financial planner. Since your situation is unique, you’ll get the best advice from someone who has the training and experience to help you define and reach your financial goals.

When seeking professional input, make sure you speak with someone who isn’t working to sell you a financial product. Many financial planners, tax professionals, and insurance agents work on commission. They may try to steer you toward making a decision or choosing a particular investment that yields the highest commission, instead of advising you correctly.

Good financial advisors won’t push you to make a decision about something you don’t understand. They should offer a wide range of services, including advice about college savings, taxes, real estate planning, and long-term care planning.

Financial planning doesn’t have to wait until you have so much money that you don’t know what to do next. No matter your financial situation, the sooner you make a plan, the sooner you’ll start moving toward achieving your goals.

Sources:

  1. Living Paycheck to Paycheck is a Way of Life for Majority of U.S. Workers, According to New CareerBuilder Survey. (n.d.). Retrieved from http://press.careerbuilder.com/2017-08-24-Living-Paycheck-to-Paycheck-is-a-Way-of-Life-for-Majority-of-U-S-Workers-According-to-New-CareerBuilder-Survey