It is not uncommon for individuals to experience a sudden windfall from either an inheritance, a legal settlement, a gift, or a bonus from their employer. If you have the good fortune to find yourself in this situation, there are several steps you should consider in order to make those dollars most impactful. One of the most popular questions that will arise is whether it is a better idea to pay off debts or invest those funds in the stock market.
As common as it is, the decision on whether to pay off debt or invest is anything but cut-and-dry. Many people wonder whether they should immediately eliminate any existing debt and focus on investing later or invest their money in the markets now and stick to regularly scheduled debt payments. Unfortunately, there is no one-size-fits-all solution.
The choice depends on whom you ask. Theories about balancing investing with debt vary widely. Some say freedom from debt is the most important goal. Others will say it is all about investing as early as possible and then applying investment earnings to paying off those debts somewhere down the road.
If you are like most people, you will need to manage your finances for both present and future needs. That means paying off some debt today while simultaneously investing and maintaining a positive outlook towards your future financial goals. With either decision, you should consider your own financial needs and circumstances. Factors like time horizon and liquidity needs tend to have a large impact on the decision-making process.
Before paying down debt beyond any required monthly payments or settling on an investment strategy, make it your top priority to reserve funds for an emergency. Most financial advisors recommend clients set aside anywhere between three to six months of living expenses. These funds should be held in a traditional savings account or a similar short-term, highly liquid, non-volatile type of account. That way, if you were to experience an interruption in income or an unexpected medical expense, you would not be at the mercy of the ebb and flow of the stock market.
Another rule of thumb is that your long-term investment plan should take priority over applying extra money toward debt. This includes saving for a milestone such as retirement. At a minimum, you want to contribute to your workplace retirement plan to the extent that your employer is willing to match your contributions. For example, if your employer matches the first 5% of your salary contributions dollar-for-dollar, then at a minimum, you will want to contribute that amount. By contributing to a long-term investment plan as early as possible, you lessen the amount that will need to be contributed to reach your retirement goal over time.
With an emergency fund in place and your retirement savings goals on track, putting any extra money towards debts each month is a sensible approach. But how do you decide which debts to focus on? The answer is to pay off any unsecured and high-interest debt first. That is, any debt with an associated double-digit interest rate, or not attached to an asset, or both. This includes private student loans, personal loans, credit cards, and in some instances, vehicle loans.
Once you have tackled those high-interest debts, it is then a good idea to consider building an investment portfolio. You will want to review your budget to determine what part of your cash flow can be directed to your investments.
Since the long-term average annual return of the S&P 500 index is about 8%, it is a reasonable assumption that you will be better off paying down any debts with an interest rate higher than that. Federal student loans and mortgages might be lower priorities since their rates are often lower and their term lengths are longer. Student loans and mortgages also come with their own set of tax advantages since some tax filers can write off the interest associated with student loans and mortgages, depending on household income.
As you set out to divide and conquer debt, do not forget to consider the emotional side of the equation. If paying off a certain debt will help you sleep better at night, you might want to go with your gut feeling.
