Perhaps one of the biggest financial questions is what should i do with
extra money first off if you do find yourself with extra cash on hand at the
end of the month then pie yourself on the back
because 78 of americans live paycheck to paycheck
and never achieve the sentiment of having leftover money
moreover it is good that you are assessing what to do with the money
rather than just blowing it on another materialistic item you
definitely don't need what you may be asking yourself
is how can i put this money to the best financial use
and in this video i will answer the long-standing question
of whether you should pay off debt or invest and if you're new to the channel
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as i just mentioned it is great that you have cash in hand to use to better your
financial position whether that was from reducing your
monthly expenses negotiating a raise at work or supplementing your income with a
side hustle the more disposable income you gain
access to the more you will profit from the advice i'm about to share with you
now before we get into the financials on whether you should pay down debt first
i think it's important to understand the psychology of this decision
for example while it may make financial sense to put aside extra cash for
investing you may be more passionate about
becoming debt free and less motivated to save for retirement since it seems
so far off if that's the case you'll be more willing to make sacrifices to pay
back debt on the other hand if you're excited
about retiring early it may be easier to live on a tight budget and invest for
that goal than to live frugally to pay off a car loan early
what i am trying to say is that it won't simply be the more economical decision
that you may go with in the end as humans we are at the mercy of our
emotions and that almost always plays a role in how we spend our money
in fact if you find that your emotions aren't aligned to the decision that is
the most financially fruitful then you have two options option one is
to accept a lesser return but be aligned to your emotions
or change your mindset and capitalize financially there is no right answer in
this case it is merely a personal choice you will have to make for yourself
there's one caveat that needs to be addressed before we get into the answer
of whether you should pay down debt or invest your extra cash
and it relates to the first option of debt repayment i need to stress that you
must make your minimum debt payments before allocating money towards any
other goal including the two options we are
discussing in this video not making a required debt payment or
paying late can be a financial catastrophe
you could damage your credit score which could make borrowing in the future
difficult or impossible you could also incur
substantial late fees and in some cases trigger penalty
interest rates that substantially increase repayment costs
you could even face foreclosure or repossession if you don't pay your bills
therefore before you do anything with your money ensure your minimum balances
are covered alright so let's now dive into when it
makes sense to pay down your debt first as this is one of the two options you
are considering for that extra money you have on hand
when it comes to debt the choice is often made for you
this is the case when you have high interest debt that's costing a fortune
dedicating extra money towards repaying high interest consumer debts like your
credit cards is likely to leave you financially
better off than investing let me share with you an example to prove this point
let's say you owe around sixteen thousand forty eight dollars on a credit
card at fifteen point five percent interest
the average interest rate for cards in 2020 and the average credit card debt
for households that carry a balance if you made a median income of fifty seven
thousand six hundred and seventeen dollars a year
and saved twenty percent of that income you'd have around nine hundred
and sixty dollars per month to put towards financial goals
if you paid the entire 960 dollars per month towards credit card debt
you'd be debt free in 19 months and would pay a total of 2
162 dollars in interest but if you paid only 300 towards a credit
card it would take you 92 months or 7.66 years
to become debt free and you'd pay 11 547 in interest with the first approach
you'd have to forgo investing for 19 months but could redirect the entire
960 dollars towards investments after that
assuming a seven percent return you'd have around eighty five thousand
five hundred dollars saved in a 401k by the end of 7.6 years
even with investing nothing for the first 19 months
with the second approach you'd be able to invest the entire 7.6 years you were
working on debt repayment but would only be able to invest 660
dollars per month because 300 would go towards your credit
card you'd end up with around 71 000 after 7.6 years
in this case the interest on your debt is higher than returns you're likely to
earn by investing in short the higher the interest on your
debts the bigger the discrepancy between extra interest paid versus
investment gains with high interest debts being a clear
priority over investing this doesn't mean that every form of
debt should be the first thing you put your money towards
as you probably guessed lower interest debts will not be as costly
and will make for a less lucrative way to use this extra cash
for example if you have a hundred thousand dollars worth of student debt
that is charging you three percent then you'll be required to make payments of
roughly a thousand dollars if you aim to have it paid off in 10 years
over the course of those 10 years you will have paid almost 25
000 in interest for a grand total repayment of 125
000 however if you were to use that a thousand dollars a month instead and
invest into your 401k for the same 10 year time frame
at seven percent you would end up with a hundred and seventy three thousand
dollars having earned more than fifty thousand
dollars in interest this fifty thousand dollars is double the interest
you will be paying on your student loans which proves that it really depends
what debts you are paying down when making this financial decision
now those who are more advanced in their personal finance wisdom will make the
argument that the benefit of paying down debt is
that it is a guaranteed return whereas investing may not yield the
return you are hoping for effectively if you pay down debt you are
guaranteed a return at the cost of its interest
whereas with investing the true return is never guaranteed
however this logic isn't as clear-cut as you would initially think
here's why if you have a 30-year mortgage the mortgage gets
cheaper over time because one dollar today is worth less tomorrow
because interest savings doesn't begin to accrue until years have passed
any interest savings needs to be discounted from our current student debt
example your thousand dollar monthly payment
will be unchanged for the 10-year time frame
but it would cost you only 744 dollars in today's dollars
the 25 000 in interest savings would also start accruing after 10 years
so it would be worth less than 20 thousand dollars in today's dollars
assuming a three percent inflation rate since inflation makes the guaranteed
return very small when paying off low interest debt early
you could invest conservatively and still get a higher rate of return
this is especially true if you get a tax break for investing
or a 401k match from your employer both of which effectively provide a
guaranteed return equal to the value of the tax savings or
matching money one final factor you must consider when it comes to the choice
between paying down debt and investing is
whether or not you can consolidate your loans
you see you can reduce your interest rate on your highest interest debts like
your credit cards by using a credit card balance transfer
often you can get a low promotional interest rate such as zero percent
financing by moving your debt from a credit card
with a high rate to the new card and have
access to a prolonged period where the cost of that debt is significantly lower
it means that you can consider investing during that time frame since your
returns will be greater than your interest fees
and then assess your strategy when the time period ends
now there is one more important element to consider when making this decision
and it relates to everyone's favorite financial topic
tax there will be tax implications associated with both investing
and certain types of debt repayment and you need to factor those into any
calculations for example if you invest in a 401k or
ira you get tax breaks for investing if you invest in a 401k the amount you
invest will be deductible for tax purposes
meaning that your current year tax bill will be lower
which is always something you want to strive to attain on the other hand if
you invest this extra money into a roth ira
the money is taxable now but the cash goes into your portfolio
and will be accessible tax-free when you withdraw it which you will appreciate
in your later years now whether you realize it or not there are always tax
advantages on the debt side of the debate
if you have mortgage debt you can deduct the interest paid on up to 750 000
in debt or up to a million dollars in debt if your home was purchased before
december 16 2017. finally if you have student loan
debt you can deduct up to 2 500 in student loan interest from your taxes
you don't need to itemize to claim this deduction but it does phase out for
higher earners at this point you may still be wondering
what the best option is when it comes to paying down debt
or investing and again it is a personal decision
but let me tell you how i would approach the situation like i said earlier you
must pay your minimum balances this is non-negotiable then i would aim
to pay down all my high interest debt that is
charging me more than the stock market historical return of seven percent
that is assuming i couldn't transfer it to a lower interest debt instrument
once i have that high interest that paid off i would then start using my extra
cash to invest on an ongoing basis while trying to increase my income
however this is just my personal take and isn't for everyone which is why i
want to share with you one other option that may appeal to you
the third option is to divide up your extra money and do both
dividing your efforts makes it harder to score wins and maintain momentum because
you don't get your debt paid off as fast or hit investment milestones as quickly
still you can get around these motivation problems by taking steps such
as automating debt payments and automating contributions to
investment and saving accounts if payments are automated you won't have
to make the choice to do the right thing every month you can also use other
techniques to cut spending such as writing down your financial goals with
clear deadlines for yourself or paying only cash instead of relying
on credit cards the important thing is that you find a
way to stay motivated and make informed choices about how to
use your extra money so you can end up with the highest net worth in the long
run thanks for watching if you want to go
from the life you have to the life you deserve
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