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How to decide whether to pay off debt, invest, or both

Unless money grows on a tree in your backyard, one of the difficult financial decisions you need to make each month is deciding how much money you should allocate to paying off loans and how much to invest for future expenses such as retirement.  With the recent roller coaster rides of the market, it might seem appealing to concentrate more on paying off any loan that you have to avoid market losses.

Becoming debt-free as quickly as possible is a noble goal, but, you might be missing out on the beauty of long-term investment income despite market volatility.  The primary reason is a concept called compound interest.  When you earn interest on previous dividend earnings. 

Compound interest is what allows a 20-year old to only invest 10% of their paycheck for retirement, but requires a 40-year old to invest at least 40% of their income to hopefully get the same account balance at retirement.  Even though the 20-year old is contributing less per month, the interest accumulated over the years can allow them to have more retirement money than a person who doesn’t set aside their first dime of retirement until they are 40-years old. 

Interest vs. Rate of Return

In recent years, it has been a challenge picking stocks and funds that consistently yield a positive return.  This has caused many millennials to avoid the stock market and spend every spare penny on repaying their student loans instead.  To be fair, the average 2016 college graduate has $37,000 in loans and the monthly payment might be a large chunk of their paycheck.

But, it’s still important for any new college graduate to contribute something towards retirement, even if it’s only $10 per month.  It’s impossible to earn compound interest unless you invest in the market.  And the chances of discovering the next “Cinderella” stock such as Amazon or Apple is about as likely as winning a lottery jackpot.

You need to make the minimum payment on any loans you currently have and strive to save at least 10% for retirement.  Once the minimum loan payment & retirement investments have been made, you should look at the best rate of return. 

Using a loan payoff vs invest calculator to show how much you need to contribute monthly to meet a financial goal can help you make this decision.   

Loan prepayment might make more sense if the interest rate is several percentage points higher than the current investment yield of a prospective mutual fund.  For example, it might make more sense to prepay a personal loan with a 12% interest rate compared to investing in a mutual fund that has a historical return rate of 4%, but, it’s harder to justify not investing if you have an auto loan with 0% APR. 

Diversification

The important thing to remember is diversification.  Investment advisers recommend owning a broad range of stocks and mutual funds to minimize risk.  The same concept applies when determining how to improve your financial condition.

It makes sense to do a little of both.  Paying off debt and investing for the future.  Diversifying your spending helps you pay for the present while preparing for the future.

Attacking the loans with the highest interest rates today means fewer and smaller monthly payments in the coming months.  With bank interest rates near zero percent, investing today creates the potential to accumulate more wealth than waiting to start after the loans have been repaid.

If you want to invest once you become debt-free, you might not begin saving for retirement until it is time to retire.  Especially if you take on a car loan or home loan after paying off student loans.  It’s always easy to find ways to borrow money to upgrade to a better standard of living and it’s even easier to overlook retirement in the process.

What’s Best For You?

Each person has a different and unique financial situation.  But, each person should be doing a little of both, repaying loans and investing for the future.  If you are currently debt-free, you should focus more on investing, but, can prepare for the next large purchase by setting money aside in a designated savings account, that way you will hopefully be able to pay for it in cash.

If you decide to focus more on repaying any loan you might have,  you should contribute the minimum to qualify for an employer 401k match or 10% (for 20-year olds) to avoid falling behind in retirement savings.  Once you become debt-free, dedicate as much money possible that previously paid the monthly payment to be invested instead.

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