Should I Invest My Extra Cash or Use it to Pay off Debt?

To answer this question, you have to decide how your money can work best for you. Compare the money you might earn on other investments with the money you would pay on what you owe others (aka debt) including credit card companies, student loans, banks, etc. If you would earn less on investments than you would pay on your debt, then it is time to consider paying off your debt.

Let’s assume that you have $1,000 in a savings account that these days earns an annual rate of return of  1 percent. Meanwhile, your credit card balance of $1,000 incurs annual interest at a rate of 19 percent. Your savings account thus earns $10, while your credit card costs $190. Your annual net loss is 18 percent, or $180, the difference between what you earned on the savings account and what you paid in interest on the credit card balance. It’s even worse when you consider the tax effect. The interest on the savings account is taxable, and you have to use after-tax dollars to pay your credit card bill. In this instance, it would be best to use your extra cash to pay down the high-interest debt balance.

Let’s look at another example. Say you have a student loan of $1,000 that you are repaying at an annual interest rate of 5 percent. Instead of paying off the debt, you invest $1,000 earning a 7 percent average rate of return.  Here, your best strategy would be to keep the loan and invest the extra cash, because your net gain will be 2 percent annually, or $20–the difference between what you earned on the investment, less what you paid on the debt.  Of course if you are saving up for something like a home or that’s your “safety net” money, you should consider keep the cash. Plus, getting such a high rate of return these days may be tougher than you think!

Diva Homework:

Consult your tax and investment advisor to help you come up with a plan to help you get out of debt.  You should prioritize which debt to pay off first if you have more than just one loan. In doing this you should consider not only the rate you are paying but also the tax deduction you might be getting from the interest you pay. Make your advisors your team and you will make much more informed decisions!

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