Money Girl's Quick and Dirty Tips for a Richer Life

How to Know When to Invest or Prepay Debt

Episode Summary

You'll learn a simple method to prioritize your precious resources, achieve financial goals more efficiently, and build wealth faster.

Episode Notes

Laura covers questions to ask yourself to prioritize your resources and know if prepaying debt or investing will build your wealth faster.

Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.

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Episode Transcription

If you have debt, you may be unsure whether it's better to use your extra cash to prepay it or for investments. While I'm a huge proponent of keeping low debt levels, saving for emergencies and growing a nest egg for retirement is also important. But with only so much money to go around, how do you know which to focus on first?

Stay with me to learn the pros and cons of prepaying debt or investing! You'll learn a simple method to prioritize your precious resources, achieve financial goals more efficiently, and build wealth faster.

Hey, everyone, and welcome back to Money Girl—I'm so glad you're spending some time with me! If you're a new listener, my name is Laura Adams. I'm an award-winning author and financial expert who's been bringing money tips and advice weekly on this podcast since 2008, with over 40 million downloads.

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Is it better to invest or pay down debt?

If you're struggling with the invest-or-pay-down-debt dilemma, I'm here to help! Instead of getting bogged down by one specific money move, I recommend stepping back and considering your entire financial life. To prioritize your money wisely, ask yourself the following four questions in this order:

1. Am I prepared for the unexpected?

Life is full of surprises, and many of them are expensive! So, before investing or sending extra money to prepay debt, be sure you're really prepared for the unexpected. For instance, consider how you'd manage if you lost your job or business income or had other financial hardships. I know it's not fun to think about difficult situations, but they happen, and having a financial safety net can make coping with them so much easier.

The best defense against the unexpected is having an emergency fund, which is money in the bank that you never touch except in the most dire circumstances. How much you need depends on your household income, living expenses, and debt payments.

Aim to maintain an emergency fund equal to at least three to six months' worth of your living expenses. For instance, if you spend $3,000 a month on essentials (such as housing, utilities, food, healthcare, and debt), make a goal to keep at least three times that amount, or $9,000, in an FDIC-insured bank savings account.

If accumulating that much seems out of reach, start with a small goal, like saving $500, then $1,000, until you have at least one month's worth of security, and build from there. Even a small cash reserve is better than nothing. It could prevent you from relying on credit cards if you hit a financial rough patch.

The trick to maintaining emergency money is never spending it unless you're genuinely in a financial pickle. Some people find that keeping emergency funds at a separate institution, such as in a high-interest savings account, makes it more difficult to tap that reserve. Because you typically must initiate a transfer to your checking, it creates a slight barrier to draining the account.

The bottom line is that if you don't have a healthy cash cushion, creating one should be your top financial priority.

2. What are my potential risks?

Another important way to prepare for the unexpected and stay out of debt is to prevent risks by having various insurance. Being uninsured or underinsured means that a disaster, theft, or accident could wipe out everything you've worked hard for and jeopardize your financial future.

For starters, if you drive (even if you don't own a car), you could hurt someone and get sued for expensive injuries and medical payments. In most cases, your state's minimum auto liability isn't nearly enough.

Where I live, in Florida, you're only required to purchase a minimum of $10,000. If you were found guilty of causing injuries totaling $100,000, you'd be on the hook for the remaining $90,000. So, purchase the amount of liability that protects your net worth, not the amount mandated in your state.

Another critical coverage is homeowners or renters insurance. Lenders require home insurance if you have a mortgage—but most renters go uninsured, which is a big mistake. A renters policy is a bargain for the protections you get, costing less than $175 per year on average nationwide. Like homeowners, renters insurance covers some of your personal belongings, liability, and living expenses if you get forced to relocate temporarily after a covered disaster.

LISTEN ALSO: 10 Facts You Should Know About Homeowners Insurance

Remember that the more income and assets you have, the more insurance coverage you need. So, as you build wealth, consider purchasing an affordable umbrella liability policy that covers you above and beyond what your auto and home insurance provides.

For instance, let's return to my previous example of getting sued for $100,000 after hurting someone in a car crash. If you had $10,000 of auto liability and a $1 million umbrella policy, it would cover the $90,000 balance.

Also, everyone needs health insurance. It only takes one emergency room visit or short hospital stay to rack up massive medical bills. Plus, if you have anyone who would be financially hurt if you died, you need life insurance. If you're in relatively good health, you can protect loved ones with a $500,000 term policy for about $200 a year.

The bottom line is that you're not ready to invest or prepay debt if you don't have an emergency fund or the proper insurance. However, the exception is when you have dangerous debts, such as overdue child support, tax liens, or accounts in collections. If you have any of those hanging over your head, you must address them immediately because they can wreak havoc on your financial life.

RELATED: Calculate how much life insurance you need

3. Am I investing for the future?

Once you're prepared for the unexpected by having emergency savings and insurance, it's time to think about your future. Unless you expect to receive a significant pension or inheritance, set up regular retirement investments as soon as possible.

While most Americans qualify for Social Security retirement benefits starting at age 62, the average monthly payment in 2023 is about $1,800. That's close to the poverty level for a household of two. That means you must fund your own retirement and consider Social Security icing on the cake.

I always recommend you use tax-advantaged accounts, such as a workplace retirement plan or an individual retirement account (IRA). If you have business income, there are excellent options for the self-employed, such as a SEP IRA or a solo 401k.

A good rule of thumb is to invest a minimum of 10% to 15% of your gross income for retirement. If you do that consistently for decades, it's easy to accumulate at least a million dollars to spend in retirement!

Put your retirement ahead of creditors. Otherwise, you risk starting too late, delaying retirement, or running out of money in your golden years. So, until you're regularly investing some amount for retirement (even if it's small), it's not a good idea to prepay debt—except for those dangerous situations I mentioned.

4. How should I tackle debt?

After you're prepared for the unexpected and investing for the future, it's time to tackle your debt aggressively. But not all debt is created equal, so you need a payoff strategy to choose which ones to eliminate first.

List your debts, including your creditor, outstanding balance, and interest rate. Then sort the list from highest to lowest interest rate. In general, that's the order I recommend you eliminate them. For instance, if you have a credit card balance at 18% APR, a car loan at 7% APR, and a mortgage at 5% APR, pay down the card first because it costs you the most interest on a percentage basis.

However, in some cases, you may prefer to pay down a lower-rate account with a small balance. For instance, if your auto loan balance is $1,000, getting rid of it first may feel great. You have permission to use any debt elimination strategy that motivates you!

Paying off debt gives you a straightforward, guaranteed return. For instance, if you're carrying card debt charging 18%, paying it off is an immediate 18% return on an after-tax basis. You'd be hard-pressed to find an investment yielding that much.

However, there isn't as much benefit for prepaying lower-rate debt, such as a 5% mortgage, with tax-deductible interest, making it cost even less if you claim the deduction. Prepaying low-rate and tax-deductible debts—such as mortgages, home equity loans, and student loans—is typically unwise because you could get higher returns by investing your money instead.

So the trick to knowing if you should prepay debt or invest is carefully considering which option will likely give you the highest return over the long run. If you send extra money to non-dangerous or low-rate debt instead of investing for compounded returns, it could leave you cash-poor or prevent you from building wealth. Once you've got plenty saved for retirement, you can send extra to your mortgage or wipe out other low-rate debts.

Reasons to invest instead of paying off debt

To recap, whether you should invest extra cash or prepay debt depends on the type(s) of debt you have. It's best to pay the following on schedule and never early:

Reasons to pay off debt instead of investing

But when you have debt with double-digit interest rates, such as credit cards or high-rate loans, there's no denying that your best money move is paying them off early. Again, protect yourself by having some emergency money in the bank and insurance protections first.

If you're conflicted about a debt-versus-investing issue, you can always do both. For instance, you could invest half your extra money and use half to pay debts. And, as I mentioned, once you're set for retirement, you can use extra cash any way you like. You might use it to pay off your home, give gifts to family, or make charitable donations.