Updated: June 29, 2020
That online business you’re doing is starting to make good money, and you now have some extra cash.
It’s tempting to spend the money and buy yourself something nice. However, you’re financially smarter now, and understand that it’s important to pay off your debts first before spending on non-essential wants.
But then you ask yourself, what if you just invest that cash, so you can make more money instead? When you have more money, then paying off your debts becomes much easier too. Now, that sounds like a better idea, or so it?
It’s a normal quandary — to be confused between investing and paying off debts.
Moreover, this dilemma is quite similar to deciding if you should save money when you have debts, which I wrote about before. And if you read it, you’ll see that I recommended, “Yes, you should save money.”
Investing, however, is a bit more complicated. And that’s what we’ll try to answer today.
Why saving money makes sense even if you have debts
I define ‘saving money’ as simply setting aside a portion of your income and putting it in the bank. The reason why I recommend doing this even if you have debts to pay is because it’s for your financial protection.
If an unexpected expense happens, like you or a loved one becomes sick or emergency repairs needs to be done at home, then you’ll have the cash to spare instead of going into more debt because you have no savings.
This situation happens more often than you think. And I believe the extra money that you pay on interests is worth the peace of mind you’ll have in knowing that you have money set aside in case a financial emergency happens.
And apart from this benefit, there are also two more advantages to saving money while you’re still paying off debts. Which are:
- You may have incurred debts in the first place because you don’t know how to save. So it makes sense to learn the habit of saving as early as you can.
- You’ll have two positive affirmations that rewards you psychologically — your debts are going down, while you see your savings grow.
Thus, if you’re torn between investing vs paying off debts, but you actually don’t have savings — then you should build your savings first while paying off debts. Yes, that means you should not invest and instead, save AND pay your debts.
Investing vs Paying Off Debts
The assumption here is that you already have your savings or emergency fund, and you now have some extra cash to spare. Should you invest it or pay your debts?
The answer is it depends. And we’ll go through the different cases below.
CASE 1: SHORT-TERM DEBTS
If what you have are short-term debts, such as credit card debts or you owe someone money, then my recommendation is to pay off your debts first and skip on investing for now.
Short-term debts, especially credit card debts, incur interest fees every month. And it’s very difficult to find an investment that can consistently achieve monthly gains higher than those interest fees.
Of course, if you owe someone money, then it’s also better to pay them first because for me, relationships are more important. And also, it’s not good to owe anyone money for a long time, especially from family and friends.
CASE 2: LONG-TERM DEBTS
For long-term debts, which I also refer to as loans — such as salary loans, personal loans, home loans, car loans, etc. — then the choice would depend on which makes more financial sense.
At this point, either or both of these happened:
- You received a lump sum, such as a salary bonus, you might have won cash in a raffle or contest, sold an asset, or you had an unexpected windfall. If so, then you can pay a portion of your loan in advance, if not all of it.
- Your income increased, perhaps you now have a higher salary, began freelancing, took an additional job, or maybe you started a business. If so, then this means you can afford to pay more on your monthly dues.
The first thing you need to do is to ask your creditor if it’s possible to restructure your loan. And if so, then calculate how much you would save on interest fees if you take this option.
And then, the second thing you need to do is to research on how much your potential returns would be on the investment, where you plan to put your money at.
After doing these two important tasks, then it will become clearer which option you should take.
To illustrate, let’s say that you have a 5-year car loan, which you’ve been paying for 1 year already. Suddenly, you received a significant salary bonus, and the bank agreed that you can pay a lump sum in advance and restructure the remaining loan balance.
You now proceed to calculate the numbers, which are:
- Total interest fees on the original loan: P150,000 [A]
- Interest fees already paid in previous 1 year: P20,000 [B]
- Interest fees left to pay after restructuring: P100,000 [C]
- Potential returns of the investment: P25,000 [D]
If you don’t restructure your loan, then you’ll pay P130,000 [A minus B] of interest fees for the next 4 years. But if you restructure the loan, you’ll instead pay P100,000 [C] on interests. This means by restructuring, you’ll be able to save P30,000 [A minus B minus C].
Option 1: Invest and not restructure the loan
You’ll pay P130,000 on interests, but you’ll earn P25,000 [D]. In effect, you only paid P105,000 [A minus B minus D] on interests.
Option 2: Not invest, instead restructure the loan
You’ll pay P100,000 [C] on interests, but you’ll have no investment returns.
So, in this case, it seems that Option 2 is the better choice — to restructure the loan instead.
But of course, if you found an investment that can give you potential returns of more than P30,000 for the next 4 years, then it would be better to invest and not pay in advance.
Please note that our illustration is oversimplified. There are many other factors to consider such as inflation rate, economic conditions, and even your personal lifestyle and expenses.
What’s necessary to understand now is the process we did to arrive at the conclusion.
If you don’t have savings, then you should save while you’re paying off your debts. Do both. This has greater benefits far beyond the financial advantages.
If you already have savings and you have short-term debts, then pay off your debts first before investing. Almost always, this is the best option.
If you already have savings and you have long-term debts, then you need to calculate the numbers to find out which option makes more financial sense.
Lastly, if you don’t want to go through the meticulous task of calculating the numbers, then you can hire a financial planner to do it for you.
Or, as counterintuitive as it may sound, you can actually just do whatever feels better for you — to invest, to pay off your debts, or even to do a little bit of both.
Because if you think about it, regardless of which option you choose, you will always end up in a better financial situation than where you are today — either with less debts, or with more investments.
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