Is it better to invest or pay off debt? : It is enough to save a little money for doubt to arise.
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What is better from a financial point of view? Is it better to end debt or start investing? As with the question of whether to save or face debt , there is no single answer and it depends greatly.
It depends mainly on the type of debt and the type of investment . Based on this data, you can choose to pay your debts sooner or start investing.
What there is is a basic golden rule to make the best financial option and a series of tips to make the best decision for your specific case (or at least a well-informed one).
Is it better to invest or pay off debt? : The Golden Rule
In this section we are going to focus exclusively on the financial component. In other words, which of the two options will give you the most bang for your buck . So simple and aseptic. And here the basic rule, the golden rule to decide whether to invest or end debt is very simple: choose the option with a higher interest rate .
In other words, if you have debt on which you pay an interest rate of 5% and can achieve a return of 8%, investing should be your first option. This rule of thumb is fine as a starting point, but it leaves out a key issue: risk . Every investment involves assuming certain risks, which will normally be greater the higher the profitability .
The same does not happen with the payment of debt. The performance or profit is certain and, furthermore, you know it in advance. That is, paying debts sooner is safer than investing.
Pay the debt if it has very high interest rates
The key here is to know what is considered high interest rates. Again, it depends on your profile as an investor and your own risk aversion. As an example, the average annual historical profitability of the stock market is around 8% for long-term investments .
Any debt with more interest than that 8% could already be considered high.
Of course , if the rate is already closer to 20% , like with revolving credit cards, you shouldn’t hesitate to get rid of that debt first. The long-term advantage of doing so will be enormous. In fact, you could even claim it as usurious interest . With this form, experts will analyze your particular case.
Invest if the interest on the debt is low
On the contrary, if the interest rate on the debt is low, investing can help you generate more wealth in the long term. This is what can happen with a mortgage or 0% financing, for example.
Of course, when choosing where to invest your money, it is important to choose products appropriate to your risk profile, with an expected return higher than the interest rate on the debt, and that have a certain liquidity, in case you need to recover those savings.
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The balanced option: pay off debt and invest at the same time
Life is not made up of blacks and whites, not even in this decision. You can combine debt payment with investment from the beginning if you already have money saved.
You just have to adapt the general advice you just saw to your particular circumstances . If you have debts with very high rates, make them your absolute priority because ending them will be the most profitable option.
From there, you can divide the rest of the money between the lowest debts, which are in line with the interest that you can get by investing your money in the long term, and the investment. This way you will combine the best of both worlds.
On the one hand, you will be paying your debt more quickly and that will allow you to sleep more peacefully.
On the other hand, you will start investing and will be able to better take advantage of the power of compound interest. And your best weapon to grow your money as a small investor is time.
Transform debt savings into investment
A very interesting option at this point is to allocate the money you were paying for your debt to invest . This way you will avoid falling into the trap of increasing spending and spending that money on other things.
So that you understand it better, nothing like an example . If you have used your savings to pay off the car loan for which you paid 200 euros a month, what you should do immediately afterwards is transfer those 200 euros to your investment or savings plan. This is how you will truly change your life.
If you don’t, it’s easy to end up spending that money on something else and not on growing your financial freedom.
How to make your decision
Now that you know the numbers, all that remains is to adapt them to your specific case. To do this, follow the general advice for your higher rate debts and act at your discretion where you have concerns.
A question that can help you decide is to ask yourself how you will sleep better at night , knowing that you are debt-free or that you have already implemented your investment plan.
What to do with the house?
This is the most common variable of doubt. In other words, I pay off the mortgage or invest . We have a specific article where we do calculations and resolve the question between paying the mortgage debt or investing. You can see it here: How to know if it is better for you to pay your mortgage sooner .
And if you are clear about it, but you doubt between installment or term , the answer is here: Installment or term, which is better to amortize in the mortgage?
What if you don’t have money, but you do have the ability to save?
This is usually the most common case. People who can save money every month, but do not have money to save. At the end of the day, the normal thing is to save first and, with that savings, gather some capital with which to decide.
If this is your case, the question is whether it is worth it to just save, pay off debt or invest . Again, there is a very simple golden rule: if you don’t have a cushion for unforeseen events, you shouldn’t consider anything other than creating one. This should be your priority because this way you can sleep more peacefully.
From there you can choose to use that savings capacity to pay off debt or invest . Unless your savings capacity allows you to go beyond 150 euros per month, the best strategy is usually to start with the debt using the waterfall method to end the debt .
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What’s the best approach for deciding which debts should be prioritized for repayment? When in doubt, start with the smallest debts, which are the easiest to eliminate.
Once you are done with the debts, you only have to transfer that money that you have freed up to your investment plan, which is what will really help you achieve financial freedom.