Whether you are fresh out of college or well into your adulthood, learning the fundamentals of personal finance is instrumental to your financial wellbeing. Financial Planning Fundamentals, Part One introduced us to the first set of steps we can take to build confidence and positive habits. Now, we can focus on a more specific conversation: paying off debt vs. investing.
Making the Decision: Pay Off Debt or Invest?
There are two main ways to decide whether you should pay off your debt or start investing:
#1 – Review interest rates on your loans and compare against potential investment returns.
Example #1: You have a large balance on a credit card with an interest rate of 15%. Even if you are invested in an aggressive portfolio, your investments would return about a 7-10% annual rate of return. If you chose to invest your money instead of paying off this loan, the returns you earn in your investments would be dragged down by the interest payment on your loan, if not negating your returns entirely. Therefore, in this case, prioritize paying off this credit card before directing your money into investments. Below are some methods for paying off debt.
Example #2: You have a car loan at a rate of 3.50%. In most investment portfolios, you’ll receive more than a 3.50% annual return. In this case, prioritize investing since the interest rate on your loan is less than potential investment returns. Below lists key points to consider when investing.
#2 – Consider the impact of your loans on your credit score.
Example #1: You have a poor credit score and plan to finance a home. If you finance a large purchase like a home with a low credit score, your interest rate will be high, and you’ll pay an unnecessary amount of interest over the life of your loan. A high interest rate also increases your monthly payment which in turn reduces your positive cash flow. Therefore, it’s crucial you build up your score. See the credit focused debt pay off method below for additional information.
Paying Off Debt
Once you have decided to prioritize paying off debt, it is time to ponder your primary goal. It will assist you to decide which debt payment method works best for you.
Primary Goal #1: Pay the least amount of interest and/or pay off your debt the fastest.
Method to use: the Avalanche Method. The avalanche method targets your highest interest loans first. Your loans will be paid off faster than using other methods since the high interest debt is eliminated first.
Primary Goal #2: Increase your credit score.
Method to use: Credit Focused Debt Pay Off. Using this method, target consumer debt first, like credit cards. Your goal is to have a credit utilization ratio of 30% or less.
Example: You have two credit cards that are both maxed out. One card has a $1,000 balance and the other has $3,000. Begin by paying down your $1,000 card to $300 (30% of credit available). The algorithm which calculates your utilization ratio only pays attention to the percentage, not the amount. Once you have paid this card down to $300, then direct attention to the card with the $3,000 balance and pay it down to $1,000 (30% utilization).
Primary Goal #3: Peace of mind or psychological motivation.
Method to use: the Snowball Method. The snowball method appeals to our psyche by targeting the lowest balance loan and knocking them out one by one. It is psychologically attractive because you build momentum as your debts vanish.
Investing
Investing can seem intimidating, but you simply need to focus on what type of account to use, where to open the account, and lastly, choosing investments.
Account Type
When choosing the type of account to invest in, first ask yourself if you want to have access to the funds before retirement. If so, invest in a taxable account. Any income or gains you receive in this account will be taxed when you file your taxes, but it gives you the freedom to use it before retirement. If you do not plan to access the funds before retirement, invest in a retirement account. Retirement accounts offer tax sheltered growth. This also means you can face penalties if you withdraw the funds before retirement. There are some exceptions, but a good rule of thumb is to invest in a retirement account with the intention of using it when you retire.
Roth IRA’s and Roth 401k’s are a great option for a retirement account if you qualify to contribute to them. They offer special benefits and features that Traditional IRA’s or 401k’s do not offer. The main difference between a “Roth” retirement account and a “Traditional” retirement account is the tax status of the contributions. The money contributed to a Traditional IRA or 401k’s is pre-tax. In Roth IRA’s and Roth 401k’s, it is post-tax. If you have the option to invest in a “Roth” retirement account, it is typically wise to take advantage of the opportunity.
Open Your Account
Choosing where to open an account is also simple. A few of the most common financial institutions are Charles Schwab, Fidelity, and Vanguard. It is likely your employer retirement plan uses one of these custodians. Some find it simple to open any new accounts at the same financial institution their employer plan is at.
Choose Investments
Lastly, choosing investments can be complicated, especially without proper training or education. There is an abundance of options and many components to consider when investing. I highly encourage you to entrust an expert to craft an investment portfolio based off your needs, wants, risk tolerance, and financial goals. Think of it like going to the doctor. While you might take care of yourself, it is important to check with your doctor to make sure you are in good health and on the right path; or you may learn “treatment” is necessary.
The End Goal
Whether you deploy your money into paying off debt or into investing, the end goal is to put your money to work for you to make the most of your money and your time. Your future self will thank you.
Sign up for our newsletter at tenbridgepartners.com or give us a call if you are ready to take the next step and define your path forward. We would be happy to meet with you to provide you confidence and clarity in your financial life.
From the desk of Sirra Anderson-Crum FPQP™
The information contained in this correspondence is intended for general educational purposes only and as a means for facilitating a conversation. Please consider our door always open to discuss your particular situation and how this information might benefit you and fit your specific needs.