What’s Smarter – Paying Off Debts or Investing?
It probably doesn’t happen as much as you’d like, but you may occasionally have some extra disposable income. For example, perhaps you have recently received, or will soon receive, a year-end bonus. Or maybe you will get a sizable tax refund in just a few months. Wherever this money comes from, you will want to put it to good use. Should you use the cash to pay down debts or should you invest it instead?
There’s no simple answer, and everyone’s situation is different, but here are a few suggestions for helping you make a good choice:
Evaluate your cash flow. If you already have enough cash to meet your daily living expenses, you might lean toward investing the money, but if you are just getting by, possibly due to heavy debt payments, then you might be better off using your newfound funds to reduce your debt load. Another way of possibly reducing your debt load is to build an emergency fund containing three to six months’ worth of living expenses, with the money kept in a liquid, low-risk account. Once you have such a fund, you could use it, instead of going into debt, to pay for unexpected costs, such as a new furnace or a major car repair.
Evaluate your debts. Some of your debts are actually more “expensive” to you than others. This expense level doesn’t necessarily refer to the size of the debt, however. You might have a large mortgage, for instance, but because your interest payments are typically tax deductible, your “after-tax” interest rate may be relatively modest. Therefore, you might consider using your excess cash for investments, rather than paying down your mortgage. But if you have consumer loans or credit cards that carry a high interest rate and whose interest payments are not deductible, you might be better off paying down this debt.
Evaluate your investment opportunities. You may have heard that one season or another is a “better” time to invest – but there’s really no strong evidence to support this claim. However, now that we are nearing the end of the calendar year, and only a few months away from the tax-filing deadline on April 15, you may want to take advantage of at least one time-related investment opportunity.
Specifically, you could use whatever extra money you have to fully fund your IRA, if you haven’t done so already. For the 2018 tax year, you can contribute $5,500 to a traditional or Roth IRA, or $6,500 if you are 50 or older. (Depending on your income, you may not be able to contribute the full amount to a Roth IRA.) You’ve got until the April 15 deadline to fully fund your IRA, but if you have the money sooner, why wait? The quicker it’s in your account, the faster it can go to work for you.
One final suggestion: If you have a company match as part of your 401(k) or similar retirement plan at work, consider contributing enough to get your employer’s full matching contribution before you pay down debts – don’t leave this “free money” on the table.
Your year-end bonus, tax refund or other source of beyond-the-paycheck money can help you make progress toward your financial goals – so evaluate your situation and options carefully before making any moves. It will be time well spent.