Following an investment strategy is the only way to build wealth but you must balance it well with the debts you carry. The balancing act between investment and debt is quite tricky, and most people face a dilemma about how to achieve it. What kind of weight does each require is the most puzzling question that individuals have to face keeping in mind that both investment and debt are equally crucial for enjoying prosperity. Neglecting repayment of debt can entangle you in a debt trap due to the high rate of interest. Investment is necessary for accomplishing your financial objectives and at the same time relying on debts help to maintain financial liquidity for a comfortable living.
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When you have excess cash, you have to decide whether to pay down debt to increase monthly cash flow or invest it for higher growth that not only takes care of the debt but also provides additional money that multiplies wealth. The problem is if you pay too much attention in paying off the debt you may not be able to invest enough to build assets and accumulate a decent fund to take care of your old age. On the other hand, being too aggressive with investment could turn into a disaster as you might lose all the money. The ideal approach in deciding whether to pay off debt or invest is to consider the best options for investment by looking at the cash flow situation and risk tolerance ability.
Compare the bottom line
While investment seems easy when you have extra cash available paying back debt might not be a straightforward decision because of the nature of debt. Debts can be of different types, and you must understand the kind of debt to decide if paying back would be a better option. Consider the outcome by comparing what would be the after-tax return on investment and the cost of borrowing after deducting taxes. The after-tax figures of both debt and investment form the bottom line for comparing the numbers in its true perspective.
All debts are not bad
All debts are not bad, especially those that provide tax benefits. Suppose you have a mortgage for a home loan for 25 years with an interest of 6% and you are a salaried person belonging to the 35% tax bracket. Since you would earn tax deductions for a mortgage up to a specified limit, your tax liability reduces and the effective interest you pay on debt could be around 4%.
When loans have the element of tax deductibles, it can save you money like taking student loans. The IRS allows deduction of tax which is lower between the interest paid actually for higher education expenses and $2500. However, the benefit tapers away at higher income levels.
For those who invest in diversified portfolios of fixed income and equities, it might turn out that the after-tax investment return exceeds the cost of debt after tax. If you are investing in high-risk securities like stocks of small-cap value and the interest rate of mortgage is low, then investment would be a more rewarding option. Entrepreneurs would make better gains by investing in business rather than focusing on paying back debts. The reverse is true for those who are nearing retirement and take a conservative approach to investment.
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Understand your risk tolerance
Investments are subject to risks because of variable returns and how much you can tolerate the risk arising from it determines the kind of investment approach that would suit you. Your income and earning power together with age, tax exposure and time horizon of investment together with some other factors help to determine the extent of risk that you are likely to tolerate.
If you are young with high disposable income and have the earning ability to recoup finances that you might lose, then you should be able to tolerate high risk and invest aggressively without caring for the outcome. Even those who have to pay for high health care costs would better do to carry on with debts.
The investment pattern
Investing in cash as well as fixed-income investments is a wise decision instead of turning to high-risk equity investments or investing in risky assets. Investing as long as you are working and have an expanded time horizon has the potential of higher returns. That is because equities, in the long run, provide minimum 10% before tax return and there is no point to think about paying back debts.
Besides your financial capabilities, another aspect of risk tolerance comes from your mental condition that determines your willingness to take risks. If you cannot accept losses, then you turn to be a conservative investor who wants to play safe, but if you are ready to lose money within tolerable limits and have the courage to fight out losses, then you have the traits of an aggressive investor.
Managing debt by building a cash cushion
Having enough cash in hand to tide over unforeseen financial crisis is the primary requirement for individuals because it works like a safety belt and you must have some money in hand equivalent to 6-month expenses. Secondly, you must maintain a debt to income ratio of your pre-tax income between 25% and 33%.
Paying off credit card debts should always be a priority because of the extremely high interest rates that it carries. It helps to save money spent on interest. Since it is essential to maintain the debt to income ratio, whenever there is a strain on the number, it is wise to pay back debts to bring the number within acceptable limits.
The better you can assess your financial situation and evaluate the environment around you, easier it becomes to decide how you could balance well between debt payment and investment. Maintaining the right perspective when setting financial goals and knowing your cash flow, risk tolerance, and investment options helps to create a balanced financial plan.
