Why Effectively Paying Down Debt is Just as Important As InvestingInvesting Insights Cash Flow
The average American has a whopping $90,460 in debt. If we narrow it down to just the average debt Gen X individuals carry, that number climbs to $135,841. Millennials, on average, carry $78,396. While the type of debt varies, the most common are credit cards, auto loans, mortgage loans, personal loans, and student loans.
Is debt weighing you down? Or torn between paying off past purchases or investing to help your money grow in the future?
What if we told you that they’re essentially the same?
- Making on-time debt payments saves you money on interest and is also great for your credit score.
- The snowball method is an excellent way to approach paying off debt if you’re unsure where to start.
- Your financial priorities will change throughout your life. If you need to focus on paying off debt now, that doesn’t mean you won’t reach your financial goals.
How Are They Different?
Before diving into their similarities, let’s first discuss their differences.
Investing is a way to set money aside for the future through assets like stocks, bonds, and real estate. Invested funds grow over time and are a long-term wealth-building strategy.
Debt is money you’ve essentially already spent/borrowed. Debt that goes unpaid usually gets charged interest. Interest adds charges to your principal balance, meaning you’ll likely end up paying more than what you spent/borrowed in the first place.
You Should Do Both! (If You Can)
Look at one of the most common types of debt, a mortgage. Is it more beneficial to make extra payments to your mortgage or invest that money?
Here’s a hypothetical situation:
- Your mortgage has an interest rate of 5%.
- Your investment has an average return of 10%.
In this situation, investing the money may make more financial sense rather than making additional mortgage payments.
But let’s throw a wrench in the plan and say you have a balance on your credit card with a 21% interest rate. Then, paying off the credit card rather than investing makes more sense.
Of course, we can’t forget that investments always carry some risk. That annual average return of 10% can’t be guaranteed, so you have to be comfortable with the possibility that the return might be lower.
How Are They The Same?
Let’s keep using the same scenario, except you decided to invest the funds rather than pay off the credit card.
How might this be a mistake? Since the return on investment will likely be lower than the credit card's interest rate, you’re not saving any money. Instead, you’ll likely end up spending more!
Your credit card balance will continue to grow, and your investment might grow at a lower rate which won’t offset the additional interest costs.
So, what’s the best way to tackle paying off debt?
Why It’s Important To Pay Down Debt
Paying down debt can impact more than just your wallet. By paying down debt effectively (AKA making on-time payments), you can help boost your credit score.
Ah, yes, the elusive credit score! Why is it so important anyway?
Your credit score has an impact on your financial life in a variety of ways. Credit scores can affect insurance premiums, whether a landlord will rent an apartment to you, whether or not you’ll be approved for a car or home loan, and much more.
Debt also carries a psychological effect with it. Carrying debt and raising interest costs can cause a great deal of stress on your financial and personal life. For that reason alone, paying down debt can be beneficial, so it doesn’t keep you up at night.
How To Pay Down Debt
If you’re thinking: “I should prioritize paying off debt, but I don’t know where to start.” We have a few ideas that could help you!
Debt can be a “slippery slope.” Once you borrow money and interest starts piling up, things can quickly get out of control, and you could slip over the edge. However, trying and pay down your debt all at once is also intimidating. It can be hard to know where to begin.
The “snowball” method allows you to gamify your debt paydown strategy. Like when you build a snowball, you first start with the smallest debt. This could be a low-balance credit card, auto loan, or personal loan. The interest rate doesn’t come into the picture at all.
If you’ve ever made a snowball (or snowman), you know you take a small handful of snow and roll it. Eventually, it picks up snow and grows. Pretty soon, you’re looking at a decently sized snowball – or a full-sized snowman (carrot nose is optional).
The idea of the snowball method of paying down debt is similar. You start with your lowest balance debt. When you pay that off completely, you take the monthly payment you were making toward that liability and “roll” it into the next-smallest debt.
This works for a few different reasons. First and foremost, you’re knocking out debt quickly. Tackling larger loans or a hefty credit card balance first can feel insurmountable, especially if it takes a long time. By paying off a low-balance liability right away, you’re motivating yourself to stay on track.
Asking For Help
If the snowball method is too much for you to approach, consider talking to your lender about changing your monthly minimum payment.
While this isn’t a great long-term solution, it can help if you’re in a tough spot and can’t afford your loan payments. You won’t be avoiding interest, but your credit score won’t be harmed if you continue to make on-time payments.
Adjust Your Financial Goals As Needed
If we know one thing for sure, your financial goals and priorities will change throughout your life.
While your goal today might be paying down debt rather than investing, you’re setting yourself up for a successful baseline to build an emergency fund, contribute to your retirement accounts, etc.
A financial advisor can be a great ally when navigating the debt repayment process. If you’re looking for the best path for you and your money to achieve your personal and financial goals, please contact us today.