Paying Debts Early Vs. Making Investments

A look at different situations where you could choose between paying off debts and investing surplus, gives pointers on deciding which option is best.

Many people begin to consider investing money when they reach the point that their income exceeds their monthly bills. Investing is an excellent way to save money, learn about the economy, and provide for your family's future. Investing money is a challenging experience that requires the individual to evaluate his personal financial situation and the conditions of numerous investment markets. When evaluating your personal financial situation, consider the amount of debt that you currently have. Determine if the debt is good or bad, the interest rates on the borrowed money, and the amount of time it will take you to clear the debt. You may often find that you will benefit by deciding to delay your investments and use your surplus finances to clear your debt more quickly.

Creating and maintaining an investment plan requires the individual to be aware of his financial situation, simply because you must know how much you can afford to invest. The process requires evaluation of your monthly income and liabilities, as well as some guesswork concerning potential future expenses. Smart investing also requires that you learn to evaluate available investment options and markets. You must become familiar with several options to decide where to invest your money. You may decide to invest in real estate and mutual funds. You will need to learn to evaluate potential real estate investments to determine if they seem to be profitable and learn which mutual funds are best suited to your investment goals. The process of investing money requires that the individual devote a significant amount of time to learning. The faster you start learning, the more time you have to build knowledge. This is the primary advantage to investing money before paying off debt.

Another advantage to investing money early is that the money that you invest has more time to grow. If your calculations determine that you would have to spend two years clearing your debt before you begin investing money, you will lose two years of potential investment growth. The amount that investment will increase in value is largely dependent on the state of the economy, however. The United States economic and stock market has been stagnant over the past few years, and investments have decreased in value. Therefore, the person considering investment during the past several years would probably have wanted to clear their bad debt before beginning to invest. The reason for this is that the investment would have suffered short-term losses, while the same amount of money applied to the debt would have maintained its value. For example, a $2,000 investment in 2001 might have decreased to $1,600. If the same $2,000 were applied to a $15,000 debt, the debt would be reduced by $2,000. So the money would have been more valuable if applied to the debt than if it was invested. There is no true way to know what will happen in the economy tomorrow or for the next year. There are several indicators that may be used to predict economic shifts, but the indicators are not exact. Therefore, your investment could make significant gains during the next year, or you may lose all of it. Paying off debt is a much safer choice because you do not risk losing anything, as your money will retain its value when applied to debt.

Paying off debt early also eliminates part of the interest that you are required to pay on the loan. Interest is typically calculated daily and applied to the balance of the debt. An outstanding loan of $20,000 may accrue interest at a rate of 12% per year. The interest each month is then 1% of the total amount owed on the loan. Therefore, if you owe $20,000 and have a 12% yearly interest rate, then your interest for the first month is $200. If you pay a bill of $400, then the second month your balance on the loan is $19,800. The interest for the second month is $198. If you pay $400 the second month, then $202 is applied to the principal and $198 is applied to interest.

Suppose you have a loan for $20,000 at 12% and your monthly payment is $400. Remember from the example above that the first month you pay $200 in interest and $200 toward the amount that you owe. Suppose also that you have an extra $400 that you are considering investing. If you apply the $400 to the outstanding loan and pay $800, the bill is reduced to $19,400. The interest for the second month will then be $194, instead of the $198 mentioned in the example above. If this process is repeated each month, the loan will be paid much more quickly, and the borrower will pay much less interest. Once the debt is cleared, the individual will have the extra $400 to invest, and he will also have the $400 that he was previously paying on the loan.

Many financial consultants advise people to clear their debt before beginning an investment portfolio. This advice is based on the fact that debt acquires interest, even when the economy is bad. Excessive debt can also damage your credit, if not managed properly. Bad investments may cause you to lose money, but they will not hurt your credit score. The individual also knows exactly what money that is applied to debt will do. It will decrease the debt. Money that is invested may grow rapidly, may not make any additional money, or may be depleted. There is no guarantee concerning the condition of the money.

The sound advice is to clear as much bad debt as you can before beginning to invest. First and foremost, pay off all of your credit cards and consider throwing them away. Secondly, pay off your car. Cars depreciate in value quickly and moderately high rates of interest are given on car loans. New car dealerships frequently offer rebates or other specials such as no payments for the first year that cause the purchaser to owe more for the car than it is worth the minute that he drives it off of the lot. Car loans should probably be cleared before beginning an investment portfolio.

There are two situations in which an individual with surplus monthly finances may want to consider investing the money before clearing the debt. The first situation is when the debt is considered to be good debt. Student loans and mortgages are typically considered good debt. Student loans are good because the interest paid is tax deductible. This means that you do not throw away all of the money that you pay in interest, because you don't have to pay income taxes for the amount that you pay in interest. Student loans also carry very low interest rates. Therefore, the individual may choose to keep the student loan payments and invest the money if he believes that his investment of choice will make significant gains before he would be able to clear the student loan debt. Mortgages are also considered good debt. Houses are typically considered assets because they appreciate in value. Therefore, you are not losing money on both ends, as when paying a car note. When paying a car loan, your are paying more for the car than it is worth because you are paying interest, and the car is decreasing in value with each payment you make. When paying a mortgage, your are paying more than the original price of the house because you are paying interest, but the house in increasing in value each month.

Another situation in which you may want to consider investing before eliminating your debt is when you need debt to provide financial structure for your life. While some people manage their finances very well each month and easily save and invest extra income, others need to pay bills in order to have financial structure. Evaluate your personal spending habits and determine what you will do with extra money. If you feel that paying off your car means that you have money to purchase a new car, you might consider keeping your current car payment and investing your current surplus. The reason for this strategy is that you will probably not shop for a car that is less expensive than the car you currently drive. Purchasing a more expensive car will actually increase your debt and require that you use some of your extra money to make the monthly payments. This will serve to decrease rather than increase your total investment, which is opposite the result you are attempting to accomplish by paying off the debt before beginning an investment portfolio.

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