Pay Off Debt or Invest?

Deciding to pay off debt or invest is a difficult financial decision.

Financial gurus such as Dave Ramsey and Suze Orman agree everyone should clear debt as soon as possible and be debt free before retirement, but sometimes paying off debt isn't the best financial decision. In some cases, you may gain more from maintaining your debts and investing your spare cash. Additionally, certain debts could be beneficial if paid over an extended period of time. Learning how to make the choice between paying off debt and investing extra cash will save you from digging a financial hole or missing a profitable investment opportunity.

Emergency Fund

If you don't have an emergency fund, paying off debt or investing extra cash should take a temporary back seat on your financial to-do list. An emergency fund is money set aside as an expense cushion, which prevents you from reaching for your credit card to cover expenses if you lose your job or main source of income. Dave Ramsey suggests starting with $1,000 and contributing to the fund until you save three to six months of your expenses. Suze Orman suggests saving at least eight months of your living expenses before paying off debt or investing extra cash.

Types of Debt

All debts aren't created equal. Financial obligations fall into two categories: productive debts and nonproductive debts. Nonproductive debts are obligations that don't appreciate in value over time, such as credit cards and department store accounts. You should pay these debts off as soon as possible before considering investing. Productive debts, such as mortgage payments, appreciate over time and the interest paid is often tax deductible. You can pay these debts over an extended period of time as long as the interest rate remains low and simultaneously invest extra cash.

Rate of Return

Assess the rate of return before deciding to invest or pay off debt because nothing beats the numbers. For example, if you have extra cash that you can invest or contribute toward debt each month, paying off a credit card with a hefty interest rate seems like a straightforward choice, but not so fast. If your employer matches at least 50 cents on the dollar for the first 6 percent of 401(k) contributions, with tax savings combined, it costs less to invest and earn money from a 401(k) than you would save by paying the credit card off early, according to Forbes.com. Contribute 6 percent of your extra cash toward the investment and use the remainder for outstanding debts. Never throw away an opportunity to invest and receive free money, even if contributing all of your extra cash to outstanding debts seems like the logical option.

Assess Comfort Levels

While numbers speak volumes, your feelings toward financial decisions are priceless. If all signs point to invest, but an outstanding debt makes you annoyingly uncomfortable, by all means pay off the debt. Additionally, if an investment opportunity seems too good to pass by and you have outstanding debts, exercise caution and take a chance on the investment.

References

• Brigham Young University: Pay Off Debt or Invest?
• Dave Ramsey: The Seven Baby-Steps -- Begin Your Financial Peace
• CNN; Suze Orman's Easy Money To-Do List; Suze Orman; Jan 2010
• University of Illinois Extension: Handling a Financial Windfall: Cash is King
• Forbes.com: Should I Save, Invest or Pay Off Debt?; Liz Davidson; August 2009
• "USA Today"; Pay Off Debt or Invest? That is the Question; Mindy Fetterman; September 2006

Resources

• Dave Ramsey: Investment Calculator
• Bankrate: Financial Calculators