Should I Use Extra Income To Pay Off Debt Or Invest?
If you’ve earned some extra income recently, it’s likely you are facing a fork in the road: Should I pay down my debt? Or should I invest and potentially grow […]
If you’ve earned some extra income recently, it’s likely you are facing a fork in the road: Should I pay down my debt? Or should I invest and potentially grow my income even more? It’s a question millions of Americans face everyday, and there is important data out there to help you make this important decision.
Here’s a summary of 5 data points that will help you quickly come to a decision on whether to pay off debt with your windfall of cash, or turn it around and invest.
- You should maintain a debt-to-income ratio (DTI) of no more than 25-33% of your pretax income. Most financial advisors strongly recommend keeping your debt payments to one third your income or less. So if you make $10,000 per month, your debt payments (including your mortgage, if you have one), should be around $3,000 or less. If your debt-to-income ratio is higher than 33% of your pretax income, it is probably wise to immediately start attacking your debt, as opposed to investing your extra cash right away.
- The interest you are paying on your debt is likely costing you more than any return on investment (ROI) you will gain, even on high-risk investments. This is especially true because your lender may use compound interest, as opposed to simple interest. Simple interest is only incurred on the principal amount borrowed. Compound interest combines the borrowed sum with interest charges accumulated over the course of the loan. Also, there is a date by which the loan has to be paid back to the lender (repayment date).
- Your age matters. This comes down to your risk tolerance. For example, a younger investor has potential to make back the money they may lose and are more likely to have a higher disposable income within their lifestyle. Thus, they are often able to invest more aggressively. The more years (or decades) of work you have remaining, the greater the payoff potential you could enjoy by investing, as opposed to paying down debt. This is partly because equities typically have an ROI (return on investment) of 10% or even more, on your pretax income, over time. If you are an older investor, you may be more likely to avoid risk with more at stake. You also have fewer years to enjoy long-term returns on riskier investments.
- It’s wise to build up an emergency cash fund. Many financial advisors, accountants, and bankers suggest having a liquid sum of cash handy in case of emergency. The amount they recommend varies–some say start with $1,000, others will suggest having 3-6 months of monthly expenses saved up. However, the latter may not be possible if you are somewhat overwhelmed by debt. With this in mind, you may want to hold off on either option: paying off your debt versus investing your extra cash. Maybe you want to start with that $1,000 emergency fund, and then start tackling your debt immediately after.
- Consider the psychology of your self-esteem. Do you see yourself as a slick investor? That Wolf Of Wall Street type willing to take the high risk, high reward approach..does that excite you? OR do you feel guilt, burdened by owing other people money? Do you hate it? Whichever one of these feelings is stronger, may be the route you want to take first. Studies show financial problems lead to poor health & depression–so it’s probably a good idea to sit down and say, “What would immediately make me feel better? Transforming into a sly investor, or declaring War On Debt immediately?”
These are specific data points and personal considerations to hopefully guide you through the difficult decision of what to do with your extra income: pay off debt, or invest?
If you’re like most Americans, attacking your debt as quickly as possible is probably the best way to start building your wealth. If you’re interested in a proven method that 1,271 of my 2018 clients used to pay off an average of $157,214 in 28 months on average, check out War On Debt: 2019 Edition.