Last week I received an email from a reader asking me whether she should start investing the money she has put aside or whether she should rather pay off your credit card debt first. This answer to this is very straightforward.
It’s better to pay off your debts first and then start investing.
The reason for that is in the majority of cases the average interest rate on your outstanding debts (especially when it comes to credit card debt!) will be higher than the average rate of return you will receive on your investments. Hence, it makes no sense to make 5% return on your investments but having to pay 15% interest on your debt. Net you lose money, so it is generally better to pay off your debts first and then start investing your extra income.
Furthermore, paying off your debt will increase your credit score and will give you more peace of mind as your level of outstanding debt moves towards zero.
Having said that, if your outstanding debt carries a low interest rate and your investments generate a higher annualised return than your cost of debt, you may instead invest and use some of the profits to pay off outstanding debt. However, as the majority of debt carries higher interest charges than the average annualised return for most financial investments, it is generally wiser to pay off your debts first.
Don’t, however, put all your excess income towards covering your debt repayments. Make sure you keep a small financial cushion of at least $500 as an emergency fund. As important as it is to pay off your non-mortgage debt as soon as possible, it’s equally important to have an emergency fund that you can dip into when unexpected expenses, such as car repair or a medical bill, arise.
At the end of the day, the decision whether you want to pay off all your debts before you start investing or not is entirely up to you. Purely mathematically speaking, though, it’s always best to pay your debts off first before you use your extra cash to invest.