Applying for loans when buying a house or car or studying at a university is a common practice for Americans. According to Federal Reserve Bank estimates, the total consumer debt of American citizens amounted to $17.06 trillion in the second quarter of 2023, and the average payment-to-income ratio, according to the results of the first quarter, reached 9.6%. This means that, on average, each citizen devotes almost 10% of their income to servicing loans.
At the same time, investment activity is gaining popularity as well. The development of digital technologies has given access to investing to many people who had not previously resorted to this practice. Now, it is possible to place investments quickly and conveniently, trade on exchanges, etc. But what if you have loans that need to be repaid? Is it worth resorting to investments, or is it better to pay off debts first if additional financial resources become available? Read the article to find out in which case investments will not interfere with the payment of debts but rather speed up this process.
Loans That Must Be Considered When Investing
When making investment decisions, investors have the greatest doubts about long-term and large loans. These are primarily mortgages, which the Federal Reserve Bank estimates as accounting for 72.5% of total loans, auto loans (9.3%), and student loans (9.2%). Short-term loans are not such a concern for an investor because they are repaid quickly. For example, popular payday loans are paid off on the next paycheck and, therefore, do not influence investment decisions. Moreover, on the Payday Depot platform, you can select a lender with the lowest possible interest rate on such loans. But with long-term large loans, the situation is not so obvious, since the investor takes on certain risks when placing investments. This means that in the event of an unsuccessful investment project, they risk losing money that could be used to pay off the debt.
General Rules for Making Investment Decisions in the Presence of Loans
Investments are attractive due to their ability to generate additional passive income. But paying off your debt quickly will also save you some money. What to choose if you have extra money that you don’t need to cover regular expenses? Listen to expert advice to make the right decision.
Step 1. Calculate Investment Profit
Making investments does not guarantee the expected profit, because a lot of adverse factors can impact the successful realization of the project. That is why the first thing you need to do is assess the expected profit as objectively as possible. Also, consider the factors that could cause these profits to decrease and the likelihood that they will come into play. Try to approach the assessment from a realistic perspective, and if necessary, ask an expert for a more accurate estimate.
Step 2: Assess Your Debts
Study detailed information about your debts, including an estimate of the cost of servicing them. Pay special attention to the debts with the highest interest rates, which it is advisable to pay off first. Calculate the amount of money you need monthly to pay off interest on your debts.
Step 3. Compare These Indicators
- If your analysis shows that the expected profit from an investment significantly exceeds the cost of paying interest, it makes sense to direct the available funds to investment.
- If the interest payment is higher than the expected profit, it is better to pay off the debts first.
- The most difficult choice is when there is a difference in favor of investments, but it is insignificant. In this case, it is still better to postpone them until the debt is paid off or to look for other investment options. Investing is accompanied by risks, and if you add the risks of not getting profit to the insignificant return on investments, the choice in favor of paying off debts seems more rational.
Step 4. Consider the Type of Debt You Have
Two other factors are important to consider when making your decision on investing. The first one is how big your debt is, and the second one is what type of debt you are covering:
- The interest rate on credit cards is usually quite high and can exceed 20%. So, if your credit card debt is quite big, you’re unlikely to benefit from investing your money instead of using it to pay off the debt. Finding an investment project with a profit of more than 20% is difficult.
- Mortgage interest rates are significantly lower and, in most cases, range from 6% to 7% per annum. It is much easier to find investment projects where the profit will be higher than this figure. However, you need to consider how much debt you have left. If it is large, 6%-7% will also be a very impressive amount that you are unlikely to receive from the investment.
That is why, in most cases, debt repayment is still a priority. Not because you please the creditor in this way but because it is more economically profitable. By receiving extra cash and using it to pay off the debt, you will reduce the principal, which means you will pay less in interest. And this difference may be more significant than the profit you can get from investments.
Still, remember that each case is unique. Therefore, you need to calculate everything very carefully, taking into account all the smallest details and not forgetting about the risks. And only when you receive all the numbers can you make a final decision.