Whether it’s a raise, a new job, or decreased cost of living, finding more room in your budget opens up new possibilities.
For many, that extra cash gets eaten up by lifestyle inflation. However, for those who want to make the most of it, deciding what to do with it can be difficult.
Often, it comes down to two options:
Should I invest and grow my nest egg? Or should I pay down my debt to avoid interest?
Like many financial questions, there’s no simple or one-size-fits-all answer. However, if you understand your goals and ‘investment personality’, you can make the best decision for your unique needs.
Understanding the basics
Before you make your decision on what to do with your extra cash, you should consider these two factors:
1. Balancing interest rates
One of the most important considerations when balancing debt repayment with investing is the interest on both the debt and the potential investment.
For example, if your investment is returning at a 10% interest rate, and your debt has a 5% interest rate, investing will increase your value approximately 5% faster than the debt will decrease your value. In this case, it makes sense to invest.
However, if the opposite is true (an interest rate of 5% on your investment and a 10% interest rate on your debt), it makes more financial sense to pay off your debt instead.
To make the right decision for you, you need to determine whether the interest on your investment or your debt will accumulate faster.
2. Personal risk tolerance
All investments come with risk (especially those that return a higher interest rate which makes investing more profitable than debt repayment).
That means investors need to be ok with the possibility they may be increasing their value one year, while losing value the next. For people who are comfortable with risk, this rollercoaster is ok. However, for some people, this may lead to increased stress, loss of sleep, and even a lower quality of life.
Before you invest, ask yourself: How much risk am I ok with? The answer will help you decide on the right path for you.
The case for investing
With its possibility for high rewards, investing can seem like the best way to leverage excess cash. However, with those rewards comes higher risk. So, when balancing those rewards against the downward pull of debt, you need to make sure any possible reward from investing can, in the long run, outpace your debt.
Pros and Cons of investing extra cash
- Potential for higher returns – A good investment can generate returns that far surpass your debt’s interest, which means you can grow your wealth faster than your debt grows.
- Emergency funds – Some investments, like Tax-Free Savings Accounts (TFSAs), can be used to save money for emergencies, so you can leverage interest and decrease the chance that you’ll have to go further into debt to deal with emergencies.
- Tax deductions – Investments like Registered Retirement Savings Plans (RRSPs) can be used to lower your tax burden and increase your ability to grow your wealth.
- Increased risk – Even the best investments can go stagnant (or sometimes into the negatives). This can cause undue stress and negative growth.
The case for paying down debt
While investment offers tantalizing possibilities, debt repayment offers dependability. After all, that debt is not going to come back once it’s paid off, no matter what the market is doing.
For those dealing with high-interest debt (like credit card debt which can be up to 20+% interest), dependability can be much more valuable than the increasingly high-risk, high-reward scenario of high-interest investments.
Pros and Cons
- Save money on interest – By paying off your debt early, you can decrease the amount of interest you pay to your lender, saving you money.
- Increase your credit score – Carrying excessive debt can decrease your credit score, making it much more difficult to get a loan, rent a home, or even cause you to pay higher premiums or interest rates. Paying down debt helps increase your credit score, and avoid the challenges of a low credit score.
- Peace of mind – For some people, carrying debt can increase stress and decrease mental well-being. Paying it down sooner can alleviate stress and greater peace of mind, depending on the individual.
- Slower growth – Paying down debt doesn’t increase your finances like investing can, so instead of helping you grow your wealth, it can only decrease your cost of living.
The best ways to pay off debt
While paying down debt can be a better choice for some people, it’s important to consider how you’re doing it. If you choose to focus on paying down debt first, here are two effective methods you can use:
Avalanche method: Starting with the highest interest debt, you focus your repayment on one debt at a time. Once the highest-interest debt is paid off, you move on to the second-highest interest-rate debt. You continue to do this until your debt is paid off.
Debt consolidation: With debt consolidation, a lender consolidates all your debt into a single loan, with one payment. This helps simplify payments and can lower your overall interest rates (especially for credit card debt).
The case for a balanced approach
When considering what to do with your extra cash, the answer is rarely simple or straightforward. For most people, the answer to whether you should invest your money or pay off debt is both.
Often, the best options blend debt repayment and investing to create a solution that will work best for your unique financial situation, your risk tolerance and your financial goals.