Juggling all your financial commitments can sometimes be a bit overwhelming. It is not an easy task to make sure all the bills are paid on time and you have put away some cash into different investment vehicles to cover your various goals. Some people end up focusing on one thing at a time, such as assiduously getting rid of all debt. The trouble with this approach is that things like retirement savings or putting money away for a child’s college education can get pushed on the back burner while time marches on and the opportunity to save towards these important life goals is lost.
If you are confused about how you should divide your limited income among your competing goals and you can’t seem to settle on whether you should be getting rid of debt or investing the money instead, take a look at the four questions outlined below.
1. Does Your Budget Have ‘Extra’ Money for Investing?
The very mention of ‘extra’ money implies that you should pay down debt before thinking about investing, but this is not a pure solution to the question. You should examine your budget to make sure that you can, at the very least, continue to make the minimum payments on all your outstanding debts. Failing to do this can incur exorbitant late fees and other charges that only add to your debt load. The point therefore is not that you must pay off all your debt but that you must not allow your payments to fall behind.
2. Have You Prioritized Your Debts?
When you have several different types of debt you must try to list them according to their interest rates and time left on the term of the loan. This helps to place a higher priority on high interest debt, such as credit card balances, that left unattended can quickly spiral out of control. It helps to focus your re-payment efforts on the debt with the highest interest first as in the debt snowball method because then you can avoid a mounting debt problem.
3. Have You Factored in the Tax Implications?
The mere mention of tax implications can make some people draw a blank, but taxes play an important part in your decision to pay down debt or invest instead. For instance, in some countries, mortgage interest is tax deductable so the effective or the real interest rate you pay on your mortgage is less than your quoted rate. Paying more on your mortgage therefore may not be the best solution because you are putting money into a low interest debt instead of investing for a higher rate of return. On the flip side, deferred annuities and other retirement accounts decrease your taxable income which means that the effective rate you realize on this type of investment is considerably higher than the quoted rate. When you are doing the balancing act to get the most out of your money you need to factor the effect of taxation on your decision.
4. Can Your Investments Outperform Your Debt Interest?
Finally, the main question must be “Can the investment you choose offer a rate of return that is higher than the interest you will pay if the money is not put into debt re-payment?” If you can earn 8% on an investment while your debt interest is only 6% then it makes more sense to invest at the higher rate.
Personal financial questions should not always be taken at face value. It often pays to look beyond the surface at the questions that lie beneath.