America is a nation of debtors, with eight out of ten households reporting they have debt. Mortgages were the most common type of debt, but other types of debt are also common. Z. B. 40% of adults have unpaid credit card debt and car loans, while only one in five americans has taken out a student loan.
Most americans also have no choice in the matter; this explains why 70% of americans believe that debt is a necessity. After all, paying for a house, an education, even a car with your own funds is out of reach for most families. Still, most would prefer not to have to incur debt, especially when they are older, because money affects perceived financial security.
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If you are one of those who have debt but don't like it, you have a decision to make: should you aggressively pay off your debt by making additional payments instead of using your excess money to save and invest??
Always pay the minimum amount
The decision between paying off debt, saving or investing always has something to do with extra cash. You must make the minimum payments before you have money available for any other goal, including saving for an emergency fund or investing for retirement.
No or late payment of debt can become a financial disaster. You could damage your credit rating, which would make borrowing in the future difficult or impossible. You may also incur substantial interest on late payments and, in some cases, penal interest. Repayment costs can increase significantly. You must even expect foreclosure or repossession if you do not pay your bills.
Once you have made the minimum payments, you need to decide if now is the time to pay off your debt as quickly as possible or if you would rather invest in one of the following things:
- Saving for an emergency fund
- Saving for a down payment on a house
- Saving for retirement
- Saving for your children's college education
- Saving for other goals such as family vacations, weddings, home investments, or big purchases
Achieving these financial goals can be very important to you, but you might also want to become debt-free as soon as possible. That's what makes it so difficult to decide where to put your extra U.S. Dollars.
You need extra money to invest, save or make debt payments.
Three out of four americans live paycheck to paycheck without any extra money. This is a problem because they cannot improve their financial situation if there is no money to invest, or to pay debts, or to secure their future. If you are in this situation, you either need to increase your income or reduce your expenses to meet your financial goals.
In that case, you can ask for a raise or get a second job. As for reducing expenses, there are many ways to do it. You can change your lifestyle, move into a cheaper house or share your car with someone in your neighborhood. You could also set up a detailed budget and make minor changes, such as. B. Clip coupons and plan meals better to save on groceries, turn your thermostat down to save energy, or spend less on clothes, food and entertainment.
Saving, investing and repaying debts are far better uses of your money than any pointless purchases that won't increase your wealth in the long run. Make the necessary changes so that you have some money left over for these purposes.
The way you save and invest
Speaking of big changes, it's important to prioritize the right kind of savings so you don't fall back into the debt trap every time an unexpected expense arises. This type of savings is an emergency fund.
Some financial experts believe that saving for an emergency fund should be a priority even over extra debt payments and the highest interest debt. Because emergencies happen inevitably. If you don't have money to cover them, you have no choice but to service surprise expenses on credit. This creates a situation where you constantly have to go back into debt and there is never any real improvement in the situation. This leads to frustration and could prevent you from breaking out of the vicious circle.
With an emergency fund, you'll be able to pay medical bills and afford upcoming treatments – or save your house or car from foreclosure.
As a rule, you should be able to service your emergency fund for three to six months. If you have high-interest debt that you want to pay off as soon as possible, you should start with a "starter" emergency fund of about 1.000 to 2.000 US dollars start. Put that amount down as soon as possible, then move on to aggressive debt repayment. Once the debt is paid off, keep paying into your emergency fund.
Mathematics and psychology play a major role in deciding whether to save or invest.
While there are some types of savings you should prioritize, there are still some complications associated with deciding where your extra money should go.
A big problem is that not all debts are equal, so you may have to make different decisions depending on what you owe to whom. Moreover, and perhaps more importantly, most people do not behave 100% rationally when it comes to their money.
Although it may make financial sense to set aside extra cash for investments, you may be less motivated to save money for your retirement because it seems so far away. On the other hand, it can be easier to live on a tight budget and save for early retirement than to be frugal to pay off a car loan early.
Do the math to see if investing or paying down debt early is the smarter financial choice by calculating interest you pay on debt against the return you may get on your investments. If the approach that makes numerical sense doesn't match the approach you would like to take, look for ways to change your mindset, such as. B. Setting clear written savings targets with deadlines.
If you still can't stay on track, it may be better to work towards the financial goal that interests you most, even if you would theoretically be better off with other money priorities. A plan you can stick to is always better than a plan that's perfect on paper but you don't implement.
The type of debt matters
In some cases, the math is clear: aggressively paying down debt is more important than saving or investing. This is the case if you have high-interest debts that cost you a fortune.
However, many people have low-interest or interest-free loans because they have taken advantage of special offers. Under these circumstances, it doesn't make sense to put most of your reserve money toward early redemption because you're making money investing while this type of debt doesn't cost much.
Many people have low-interest debt that is repaid over a long period of time, z. B. Mortgage or student loan. Repaying these debts early is therefore not always sensible in case of doubt.
Of course, it can sometimes be difficult to distinguish between high and low interest rates. If the interest rate on the debt is below the stock market's average yield of 7%, that's low; if the interest rate on the debt is above that, that's high.
Debts you want to settle before investing
Paying off as much as possible could improve your financial situation, even if early repayments delay your efforts to save for retirement or invest in other financial goals.
Let's assume you have 16.048 U.S. Dollars owed on a credit card at 15.59% interest has – the average interest rate for cards in 2017 and the average credit card debt for households in the U.S. If you have a median income of 57.617 U.S. Dollars and save 20% of that income, you would have about $960 U.S. Dollars per month to invest with.
If you steered that $960 U.S. Per month into paying off credit card debt, you'd be debt-free in 19 months and have a total of 2.162 US dollars in interest paid. However, if you repay only $300 a month, it would take 92 months – or 7.66 years – to become debt-free, and you would have 11.547 US dollars interest pay.
In the first case, you could not invest for 19 months, but you could invest the entire 960 US dollars. With a return of 7%, you would have around 85% by the end of 7.6 years (minus 19 months).500 US dollars together.
In the second case, you would be able to invest for the entire 7.6 years it takes to pay off the debt, but you would only be able to invest $660 per month because you have to pay off $300 in credit card debt. After 7.6 years, you'd be around 71.000 US dollars will be received.
In this case, the interest on your debt is higher than the returns you are likely to earn on investments.
However, if you have short term loans up to a payday with interest rates often over 300%, it is imperative to focus on repayment first and investing second. Such loans and other predatory loan products like car loans are insanely expensive and designed accordingly to force you to keep borrowing so that payment is top priority.
Debts you don't want to pay off early
There are other debts that have much lower interest rates. For example, the national average interest rate for 60-month auto loans in 2018 was 4.21%, while the national average interest rate for a 30-year mortgage as of 30. May 2018 4.64% and the interest rate for directly subsidized federal student loans between july 2017 and july 2018 4.45%.
Interest rates on this debt are lower than historical average returns for the stock market. If you decide to pay off this debt early instead of investing, you might not get the best results from it.
If you have a mortgage of 300.000 U.S. Dollars over 30 years with an interest rate of 4.64 %, your monthly payment will be 1.545 US dollars and you pay 256.241 US dollar interest over this period. If you were paying back $960 a month, your mortgage would be paid off in about 13 years and you would have 152.577.41 U.S. Dollars in interest paid.
That sounds good, unless you couldn't have invested during those 13.5 years. If instead you had just met your minimum mortgage payment and invested $960 a month in the stock market, you would have ended up with 243.197 U.S. Dollars. After 13.5 years, you still owe 212.768.93 U.S. Dollars on your mortgage. You could pay off the entire mortgage with your saved 243.197 US-dollars and you would still have 30 US-dollars.400 US dollars left.
In this case you are better off because the interest rate on your debt is lower than what you would probably earn.
Conversion of high-interest debt to low-interest debt
If you don't want to postpone the investment, but are concerned that the interest on your debt is too high, look into lowering the interest rate. If you lower the interest costs, you could stay with the payment of the minimum debt, so you have more money to save and invest.
You can reduce your interest rate by restructuring your debt. Often you can get a low interest rate, z. B. 0% financing. Move your debt from a credit card with a high interest rate to the new card, and you usually have about a year to 18 months without interest. You'll probably pay a transfer fee of approx. 3% of the transferred balance, but this option could still be far cheaper than paying 15% interest or more on your existing credit card.
You can also borrow against your home to pay off large debts. Unfortunately, this is a risky assumption, because your guilt is secured by your house. If you are unable to pay, there is a very real risk of losing your house.
With a personal loan, there is another way to lower your interest rate. If you get a good deal that is lower than the interest rate on the credit card, you could use it to pay off your credit card debt.
What about the fact that you get a guaranteed return on your investment if you pay off your debt early?
For some borrowers, one of the biggest advantages of repayment is that the "return" is guaranteed. So if you pay off the loan early, you'll always save interest. You could earn a higher return with an investment, but it's not guaranteed.
Unfortunately, the "guaranteed return" from paying off debt early is lower than it seems. While you're thinking about saving 4% or 6%, or whatever your interest rate is, don't forget about inflation and taxes.
If you have a 30-year mortgage, it will get cheaper over time because 1 US dollar is worth more today than tomorrow. In our example above, your monthly payment would be 1.545 U.S. Dollars unchanged in 14 years if you take a fixed-rate mortgage, but it would only cost you 1.021,43 US-dollar inflation-adjusted in today's US-dollar cost. The sum of 152.577 US dollars in interest savings would then also less than 100.000 U.S. Dollars worth if we assume inflation of 3 percent.
Since inflation makes the "guaranteed return" very low, if you pay off low-interest debt early, you could invest conservatively and still earn a higher return. This is especially true if you get a tax break for investing or something similar.
Early repayment penalties can affect your choice
When deciding whether to pay off your debt early, you also need to factor in any early repayment penalties. Mortgages, auto loans, and personal loans sometimes impose penalties if you repay too early. If that's the case, it often makes little sense to aggressively repay debt because much of the money you save in interest is lost in the penalty.
Look at your loan documents or call your lender if you are not sure if you have a prepayment penalty or what the amount is. Then take this into account in your calculations when determining what financial goals you should pursue.
It doesn't have to be all or nothing.
When you set your financial goals, no one forces you to put all your extra money into debt repayment or investments. You can split your extra money and do both.
However, this makes it more difficult to achieve profits, because your debts are not paid off as quickly and your goals are not achieved as quickly. However, you can get around these motivation problems by taking steps like automating debt payments and automating contributions to investment and savings accounts. If the payments are automated, you don't have to think about it every month.
You can also use other techniques to reduce expenses, e.G. B. Write down your financial goals with clear deadlines for yourself or pay only with cash instead of relying on credit cards. The most important thing is to stay motivated and make the right choice about how to use your extra money.
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