Whether you’ve received a raise at work, eliminated a monthly payment, or generated a new stream of income, a common financial planning question is how you should manage additional cash flow. Should you invest it or focus on paying down debt? There are generally two sides to this decision you should consider: the financial side and the emotional side. Let’s discuss how these factors will affect what you do with those extra dollars.
The Financial Side
From a financial perspective, running the numbers may be the most objective way to choose if you’ll invest or pay down significant debt. This method involves a straightforward analysis of your debt’s interest rate compared to the rate of return on your investments. As a simple example, imagine you’re paying a 3 percent interest rate on your mortgage, but are earning a 7 percent return on your investment. In this case, you’re essentially making 4 percent more than you’re paying in interest on your debt, so investing appears to be the most efficient use of your extra cash flow.
This example doesn’t include the tax costs or benefits associated with the debt or investment, such as deductible interest expenses or tax-deferred savings accounts. However, you can frame this calculation for any debt or investment you’re evaluating as a way to inform your decision.
The Emotional Side
While our emotions are highly complex and difficult to evaluate, they’re generally always a factor in how we view, spend, and save money. Perhaps you have significant debt that has been looming over your head for a long time. From student loan debt to an expensive monthly car payment, you can’t put a price tag on the feeling of relief you’ll have when you reach your goal and make that final payment.
Reducing your monthly payments and creating more financial breathing room will certainly decrease stress, and it can have longer-term effects on your money mindset. With more cash flow each month, you’ll have more flexibility and empowerment with what you can achieve financially—and that’s a great feeling.
Whether you’re committed to paying down your debt or investing your extra dollars, deciding what you do with your money will always walk the line between the analytical and emotional. At CCMI, we understand many factors go into your lifetime of financial planning. That’s why we strive to build lasting relationships with our clients through comprehensive, tax-efficient planning that focuses on their short- and long-term goals. If you need help making an informed decision about additional income or other financial situations, contact us today and we can help you evaluate your options.
Matt Ryan here with CCMI, doing my best to help you make smart financial decisions. In this video, I’m going to be talking about investing vs. paying down debt. This is a decision we help clients with all the time. The root of the question comes down to, “what is the most efficient use of your cash flow?” There are two competing sides to this decision I want to discuss. The first is the financial side, which involves the numbers and comparing interest rates and returns, while the other is the emotional side. This is that feeling of relief when you are finally finished paying down whatever debt you might have and all the benefits that come along with doing so.
Let’s start with the finances. We generally view this decision as a comparison between the interest rate on the debt vs. the potential rate of return on your investments. If you ultimately earn more from the dollars you are using to invest than the amount you are paying in interest, investing or staying invested is the right decision. For example, if you have a 3 percent interest rate on some kind of debt—it might be your mortgage or student loans—but your investments are earning 7 percent on average, you’re earning essentially 4 percent more than you are paying in interest, and therefore, you are better off investing.
While this was a pretty simplistic example and doesn’t account for any tax costs or benefits that might be associated with the debt or the investments, what I want to get across is that you can frame the decision this way for any kind of debt you are evaluating.
On the other side of things, from an emotional standpoint, it’s really hard to put a number on the feeling of paying down debt—especially if it has been looming over your head for a long time and it is a goal of yours to get it paid off. Getting rid of that debt hopefully reduces some of the stress that comes along with it. It can also have a big impact on your mentality going forward and how you think about money. Without those monthly payments, you’ll have more cash flow and more flexibility as to what you can do with those extra dollars. Having seen this with a number of clients, considering the emotional impact is an important factor in the decision process, even though it may not be financially optimal.
To wrap it up, evaluating both the financial and emotional decisions is an important part of the framework when deciding whether to invest or pay down debt with your excess cash flow. I hope this helps you make smarter financial decisions. If you’d like to discuss further, please reach out. Thanks for watching.
CCMI provides personalized fee-only financial planning and investment management services to business owners, professionals, individuals and families in San Diego and throughout the country. CCMI has a team of CERTIFIED FINANCIAL PLANNERTM professionals who act as fiduciaries, which means our clients’ interests always come first.
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