We constantly hear how it is important to invest money in order to provide an income cushion for retirement. This can be difficult to do if a person is facing a huge amount of personal debt and is feeling pressure to eliminate it. When working within a budget and faced with a situation of excess cash, knowing whether to invest the money or use it to pay off debt requires the consideration of several factors.
Individuals should compare the amount of interest the savings account earns with the interest rates on the current debts. The savings interest rate would need to exceed the interest rate on the debt to make the savings option a better choice. Something else to consider is that the earnings on savings is taxable, lowering the earnings rate even more for individuals in certain tax brackets.
Making a list of the debts by name of creditor, interest rate, and amount of money owed is a good way to get a comprehensive view of what is owed. The debt with the highest interest rate should be paid off first, if possible. Revolving accounts, such as credit cards, should generally be paid off before personal loans and other installment accounts. If the debt is carried on a high interest rate credit card, the individual should find out if the balance can be transferred to a credit card with a lower interest rate.
Once the revolving accounts are paid off, the individual can decide whether to pay off installment loans or invest the extra money. If the loan does not have a prepayment penalty and it can be paid in a reasonable period, paying it off may become the preferred option. If the individual has home equity debt, the general advice is to continue carrying it once it has become tax deductible.
According to financial experts, five to ten percent of monthly income should be invested in savings. An individual who is in debt should consider whether to pay off the debt before making such an investment. Making the minimum payments on the debt and creating a savings account or finding a balance between investing and paying off debt are the other alternatives. Each person will need to evaluate his or her situation and determine the correct combination of savings and payments.