Let’s say you have a sudden windfall of cash, whether from your tax refund, small inheritance, or a generous gift from a wealthy uncle. You have the urge to blow it on a family vacation, a new outdoor grill or a down-payment on a new car, but instead you decide to be practical and responsible. In these confusing economic times, you don’t want to waste extra money on something that doesn’t give back in return. Now you’re left with the ultimate question: Do you use the money to pay down your debt, or do you invest it?
As always, there is no clear-cut answer, according to Doug Como, Vice President with Cameron State Bank. However, there are a few factors to consider that may help you make the right decision.
“Whether you invest or pay down debt, you’re making a smart decision, definitely smarter than wasting the money on a vacation or outdoor grill,” Como said. “But when it comes to finances, it’s always best to figure out how you can get the most for your money. If you find yourself with a few thousand dollars, you may be tempted to pay off your high-interest credit cards, but you may also want to beef up your investment funds. This leaves you with a fairly common dilemma.”
If the potential rate of return on your investment is higher than your debt, you may want to consider investing your nice chunk of change; if not, you may want to pay on the credit card. If you have an interest rate of 18 percent on your credit card, for example, you may want to make a payment on it, because “it’s highly unlikely that you can consistently earn an 18 percent rate of return on an investment, and it’s wise to get rid of that bad debt, especially when you’re paying so much interest,” Como said.
Although credit cards are considered bad debt, and it’s usually smart to pay them down, they aren’t the only form of debt that Americans typically hold. Mortgages and auto loans are also commonly held forms of debt. It’s a good rule of thumb to invest as much as comfortably possible into a 401(k), especially if the employing company matches your contribution. Many companies will match 50 percent of the first six percent you invest, for example, which means that you make an immediate 50 percent rate of return.
“This is usually a much better idea than paying on your mortgage,” Como said. “The rate on a mortgage is usually much lower than credit cards or auto loans. Most of the time, you will make more on an investment than the interest that you owe on your home. When you want to pay off debt, it’s a good rule of thumb to start with the loans that have the highest interest rate. More often than not, those high rates are found with credit cards. If you are fortunate enough to have loans with low interest rates, then you may want to put your money toward investments.”
As always, it’s best to consult with a trusted financial advisor if you’re not sure of the best path to take.
“Financial planning isn’t always about looking at numbers and interest rates. Sometimes people want to do what feels right for them. They may be determined to get rid of the car note, even if it’s a better idea to put the money in a mutual fund. Everyone is different and we all have our own expectations and temperaments,” Como said. “A good financial advisor understands that.”
