Many may think this a surprising question, but the answer isn’t always a simple yes. Depending on your situation, it is not always the best idea. Everyone needs to ask themselves the following questions before paying down their debts early.
Are you in dangerous debt?
Some people are surprised by this question, thinking that debt is just debt. But this is not true; the type of debt you are in can vary enormously. Dangerous debts should always be a first priority and should be paid as soon as possible. These types of debt include –
- Child support payments
- Court judgments
- Delinquent taxes.
These are the type of debt that if unpaid could result in your wages being garnished, or you could even find yourself in jail. Do not ignore this sort of debt until it is too late, whatever your circumstances.
Do you have enough savings?
Having savings can be far more beneficial than paying off debt early. When all your dangerous debt is paid, think about your cash reserve. When an unexpectedly large expense occurs, having paid more than you needed to for your student loan repayment is not going to be much help to you. Or if the worst happens and you lose your job, you will need an emergency fund to live on in the meantime, even if you manage to find a new job fairly quickly. Aim to build savings that are at least the equivalent of three months living expenses – and put them in an account that is not easy to access. If it is quickly accessed then you may be tempted to transfer a small sum occasionally when you are a bit strapped at the end of the month, or if you need to buy something on top of extra expenses. Having savings can make you feel safe, even when you have debt, but remember not to overdo this principle of saving and refuse to pay off debt. You need to strike a balance and compare interest rates to check the correct course of action. If you have $27000 in a basic savings account barely earning any interest when you have $10000 worth of credit card debt accruing interest at 10%, it is probably with your while using for savings to overpay that debt. The remaining $17000 is still a good buffer for emergency situations.
Could you invest Instead?
If you have spare money each month, investing might be a far better use for it than overpaying your debts. This may seem counter-intuitive at first, but if your investments can earn more after taxes than the after-tax interest rate of your debt, investing could be a far better idea. Student loans are often a good example for this as the interest rates are comparatively low. If you can find an investment fund that gives an after tax return greater than the after tax rate of interest for a loan, then investing for the greater return may be better use of your money. This is of course risky as investments are by no means guaranteed, but less risky funds are out there and still give good returns. In some cases, even very low risk investing can be more beneficial than paying off debt early. Some savings accounts such as ISAs can have very good rates of interest. Various accounts are partly linked to stocks and shares, adding slightly to the risk but potentially adding greatly to the reward. Higher risk investing (i.e. equities trading) is not recommended when you have large amounts of debt. It is fine to do some trading if you wish, but don’t use the majority of your spare income, try to use less than 20%.
If your main source of debt is a mortgage, this can cloud the issue somewhat, as paying off more of a mortgage is beneficial if house prices rise. But if there is a chance of negative equity then overpaying is not worthwhile.
If you are struggling with whether to invest or not, seeking independent financial advice may help you see your way forward. There are many more examples of situations when you might want to invest over paying off debt.
There are many online calculators that will also help you to decide between investing and paying off debt early. But it is not always a mathematical decision. Investments may be personal in nature (say a friend’s business) and so may take priority, or you may feel like your debt is hanging over you. If only a small margin is gained by investing, your wellbeing should come first.