This past week I was reading an article talking about reasons to pay off debt or invest your money. It inspired me to actually drill down on some scenarios to determine the mathematical answer. (I know, I’m a nerd.) Based on my calculations, it seems that despite wanting to calm your psychological demons, at a certain point it makes more sense to believe in the longer term game of investing as opposed to the short term win of paying off a little extra debt… But it’s dependent on where you are in your life.
Everything with finance is based on individual situations. There is no one-size-fits-all answer for finances, and that's simply the truth. When I'm working with someone facing this same choice of investing or paying off debt, the answer always rests on exactly how close this person is to retirement. The reason it's such a pivotal part of the equation is because you don’t want debt in retirement. So, someone that is 55 or 60 years old would see a greater “personal financial plan” impact by paying off more debt because they would be closer to retirement and having no debt gives them greater freedom with their monthly cash flow. The person that is 40-years-old, though, may see a greater impact by investing the money instead of putting it towards debt because they have a longer amount of time for the invested money to grow and compound.
All this said, the answer is completely dependent on the amount of money you are considering investing or paying down debt, and the type of debt you have. Determining what to do with a $1,000 is different from $10,000. With $1,000, it'd likely serve you best saving interest on your debt rather than invested in the stock market no matter your age. However, if you have a lump sum of $10,000 or something bigger, then the benefits of longer term compounding can be really beneficial to you, more so than the benefits to putting it towards debt.
Essentially, you have to ask yourself how much you can earn on this money if you invest it versus how much interest you are going to pay on your debt.
It makes sense that larger amounts of money would see a higher impact by being invested than saving you on interest because interest is calculated on your principal amount of money. When you are paying down debt you are lowering your principal amount which means less and less interest. But when you are investing, your money continues to grow and the interest you earn on your money continues to get larger - that’s the benefit of compounding.
The biggest consideration about this specific decision, though, is still the amount of time on your side. You want to have a long period of time for your money to grow while invested. That is why if you are nearing retirement, it may be more beneficial for you to put that extra lump sum towards paying off debt rather than investing the money.
But if you are younger, then you may find it more powerful to continue making the monthly payments on your debt and put a lump sum amount towards your investments.
This gets back to what we always talk about regarding it’s about time in the market not timing the market. Every year that passes where you aren’t saving is another year that you can’t make up with regards to compounding.
So, basically investing larger lump sums at an early age can be more beneficial relative to putting that lump sum towards debt. As you near retirement, though, the benefit of having no debt is a more powerful use of your lump sum.
Like I said at the beginning, everyone’s situation is unique. If you'd like help with making a decision like this, go to yourwela.com and sign up for a free account. Then fill out your profile, securely add your financial institutions (bank, credit card, mortgage, etc.), and fill out a game plan. One of our advisors will review your specific situation and use this information to determine whether it makes more sense (and cents) to invest or to pay off debt with your extra savings. That can all be done while sitting at your desk at work or on your couch at home. That’s the benefit of leveraging technology to deliver financial advice… just like we are doing at yourwela.com.