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Is it better to pay down some debt, or should I think about investing?

If you have some extra cash on hand, it can be a little tricky to figure out whether to use it to pay down debt or invest. The best answer is: it depends.

To help you make the decision on whether to invest or pay down debt, the best place to start is make a list of everything you owe. It’s important to know what you’re dealing with. Tally a list of your debts with the balance, interest rates, and minimum monthly payments. Be sure to include everything: credit cards, student loans, automobile loans, mortgages, and anything else that has an interest rate attached to it.

A good thing to focus on after you have created your list of debts is the interest rates. A general rule of thumb to consider is that if your expected rate of return on investments is lower than the interest rate on your debt, you should pay down debt first.

Historically, the stock market has returned an average of between 9% and 10% annually. If your portfolio has an allocation to bonds, which typically have a lower rate of return than stocks, your overall expected rate of return may be closer to 5% to 7%. Taking this into consideration, if you have debt with interest rates north of 10%, it’s likely best to pay this down first. However, if you have an auto loan or mortgage with a 3% interest rate, it is probably better to invest your money, as you can reasonably expect in the long term to earn more on your investments.

The decision becomes less clear-cut when interest rates elements of debt are between 5% and 10%. Something to consider is that not all debt is the same. Some loans have the ability to be restructured rather than paid off, and it’s important to do your homework on this, as options like restructuring offer you a lot of flexibility.

After you have made a list of your debts and reviewed the balances, interest rates, minimum monthly payments, etc., it’s important to build a budget. If you don’t have a budget, make one. (Need help? Here’s a handy guide.) This will help you identify how much of your income you can spend each month toward your debt or put to the side for investing while still having enough for all your other expenses. A side benefit to building a budget is that it can help you identify areas where you could cut back on spending to pay off more debt each month or save in an investment account.

Tips for paying down debt.

If you do decide to focus on paying down some of your debt, there are ways you can make it manageable. And doing so has considerable benefits: the less you spend on interest each month, the more options you have for your money.

With that in mind, let’s take a look at some basic strategies for paying down your debt.

  • Put a pause on using credit cards. It’s hard to reduce your debt if you keep adding to it. Instead, use debit cards or cash as much as possible.
  • Decide which balance you want to pay down first. The idea here is to focus on paying down your balances one at a time. The most efficient way to do it is to identify the one with the highest interest rate and pay it off first. The other approach is to pay off your smallest balance first. Some people prefer this approach because it can feel like they’re making progress faster.
  • Know your due dates. Paying bills late can add to your debt if they result in penalties. Pay all your bills on time.
  • Consider consolidation. Consolidation loans allow you to combine your high-interest balances on a single lower-interest loan. They can help because if you qualify for one, not only are you paying less in interest each month, but you’ll also have fewer bills to keep track of.

It’s important to know that debt is not necessarily a bad thing. Debt can offer you a lot of flexibility and allow for your investments to grow as well as help you meet many of your other personal and financial goals. This is why you should review your current debt situation and decide how to best approach it to maximize your chances of achieving your financial goals.

Whether you elect to pay off your debt first or invest any extra cash you have available, be sure to do your homework before making a decision. You may even want to consult a financial advisor first. If you take your time and weigh all your options, you have the ability to make your money work harder for you — and that’s always a good thing.

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