The first few steps of your financial turnaround are simple. Get caught up on your bills. Pay off high interest debt. Build up an emergency fund. If you do those things, you’re already in much better shape.
The next step is trickier. At that point, many people have some low interest debts remaining, such as student loan debts, car loans or mortgages. At the same time, there’s also a desire to invest, particularly for retirement, but also for other life goals such as buying a home.
You have your spending under control and those high interest debts and late fees are all in the past, so you have money each month to tackle your next goal. But which goal should it be?
Advantages of paying off low interest debt
- When you make extra payments on a low interest debt, you get a guaranteed return on your money — the interest rate. When you make an extra payment now, your total balance goes down, which means that when interest is calculated on your loan, there’s less balance that accrues interest. You get the money back at the end of the loan in the form of the debt going away earlier, so you don’t have to make the last payments.
- Paying off a loan early means that your cash flow improves more quickly. When you pay off a debt, that means that less of your income goes toward a debt payment each month and more of it can go to other priorities. You might be able to change careers, for example, and you’ll be able to weather a period without work much easier.
- Your monthly bills become simpler because you have fewer of them to worry about. Paying bills becomes less hectic.
- Paying off any debt reduces “debt stress.” For many, being in debt is a source of deep stress that can cause all sorts of negative feelings and health effects.
- Eliminating debt minimizes the monthly income needed in retirement. If you don’t have a mortgage payment each month, for example, the monthly income you need to maintain your life is a lot lower.
Advantages of investing for the future
- Investing responsibly has historically offered much better long-term returns than paying off low interest debt. Even if you invest rather conservatively, over the long haul you can expect a 7% annual return on your money; with more aggressive investing, you can do better than that. Remember, these are long term returns; most investments that return well are much more volatile over periods of less than 10 years.
- If you’re young, almost any long-term investment will produce increased financial security later in life. Although directly saving for retirement is the most efficient move, investing for other goals like a home or education also produce value that will compound over the rest of your life and improve your financial situation when you’re much older.
- If you decide to invest now, you can change your mind later and do something else with the money. However, changing your mind later can result in lower-than-expected returns on your investment and may result in tax penalties depending on how you invest.
- Some types of investing offer tax advantages. For example, if you put money in a tax-advantaged retirement account like a 401(k) or an IRA, you’ll end up with a lower tax bill today. There are also tax-advantaged plans for your child’s education, such as a 529 college savings plan, that will let your money grow tax-free if it’s used for educational purposes.
- If you’re stressed out about retirement, choosing to put aside a healthy amount of money for retirement can ease that stress.
Which is the right move?
If you have specific life goals that will benefit greatly from having your monthly bills cut significantly a few years from now, such as going back to school or changing careers or having a child, then paying off all of your debt is a great option. Start making extra payments on your car loan and your mortgage and your student loans.
On the other hand, if you don’t have a pressing goal in the next few years and you’re looking more at long-term goals like retirement or paying for a child’s college education, then investing makes more sense for your life situation. If you’re aiming for retirement, start by examining your tax-advantaged retirement savings options. If you want to also save for a child’s college education, consider a 529 college savings plan, which is a great choice for most people.
Neither paying off all your debts nor saving for retirement is the wrong choice. If you’re spending less than you earn and doing something productive with the difference, you’re doing something positive no matter what you choose.
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