If you are living paycheck to paycheck and have very little money left over you may be in the position of choosing whether to invest and save your extra money or to focus your efforts on paying down debt.
If you can choose only one option, it may actually be wiser and more cost-effective in the long run to pay down your existing debt.
The Ideal Financial Situation
In a perfect world, you’d be able to invest your money into an index fund that would guarantee a rate of return close to 16%, while your finance charge on your credit card hovered at a much lower rate. With that scenario, it would make sense to save instead of paying down debt because the money you invested would earn substantially more interest than the amount of interest you would pay out on your existing debts — and paying down your debt would be much easier and faster.
However, the reality is just the opposite. The average credit card interest rate is 15.91%, according to the latest report from the Federal Reserve and the historical annual average return on an index fund is about 10% per year. And when it comes to deposit savings rates, there’s no comparison: The current average interest rate on a 12-month CD is only 0.14%.
Paying Down Debt Is Likely the Better Choice
Logically, if you can make more money on your investments than your current debt is costing you, then it makes sense to invest your extra money instead of paying down your debt. After all, you could potentially take the money you earn from your investments, pay down your debt and have money left over. But remember, when it comes to the stock market, interest rates aren’t guaranteed.
And if you’re investing the money you could use to pay down debt into a CD, money market account or high-yield savings, the amount of interest you’re charged on your credit card or other debt will almost certainly mitigate any returns you manage to accrue from your deposits.
Paying down your debt instead of investing makes a lot of sense if you think about it. If you have the choice of paying off a credit card debt with an interest rate of 16% or investing in products with rates of return ranging from a solid 0.14% to a much more risky 10%, simple arithmetic will prove the value of paying down debt over investing. Then, once your debt is taken care of, invest all you want.
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