Should you invest your extra income, or pay off debt?
This question came from Sarah, via our #52WeekChallenge Telegram group:
“What are your thoughts on using extra income to pay off loans versus saving/investing it?”
This is one of those questions that cause me to reiterate that it is called “personal finance” it is well…personal. Very personal. The answer to this question depends on a number of factors, most of which are soft factors around the person’s circumstances,personality, job security / cash flow dependability etc. Also, the interest rate determines how fast you want to repay – if the loan is expensive, then you channel all your resources towards clearing it first.
We take loans for different reasons, and the reason determines how you should approach the issue of accelerating the repayments.
- Consumption purposes – to furnish your house, to buy a car, credit card debt etc.
- To meet a need or an emergency
- To make an investment
Consumer debt
Of all types of debt, consumer debt is the most harmful, because you end up paying interest on a purchase that is not growing in value and sometimes does not have any value at all. For example if you run your credit card on a night out and fail to pay it off, the interest you are paying on that card is bringing you no value. Not all consumption debt is this way though, a car purchase for example could translate to extra income for you, and the intangible benefit of convenience which could boost your productivity. With this in mind, then it goes without saying that consumer debt should be paid off ASAP.
Emergency debt
If you borrowed to meet a need or an emergency, then the most sensible thing is to have a parallel strategy where you are saving some money (and investing it), while making extra payments on the debt. This is to avoid a situation where another need arises and you have to borrow some more. I have in the past explored the question of whether you should build an emergency fund when in debt.
Investment debt
Finally, if the borrowing was for investment purposes, then it makes sense to direct all extra income you earn towards quickly paying off the debt. I actively borrow to invest in relatively passive assets (I have made a note to do a post about this), and while the temptation to invest some more while I have debt is real, it is prudent to first pay down your debt. Also, reducing the interest you are paying on the debt boosts the returns on your investment. In some cases, prepayment will boost your credit with the lender, and frees up the facility for future borrowing.
The only kind of saving that should not be discontinued to pay off loans is your retirement saving. This should happen at all times, it is the back up plan should life not pan out.
Finally, it is not too late to join our 52 Week Savings Challenge. Save the worksheet and make 2017 the year you save substantially from your spending.
