By Lee Sherman
When you find yourself with extra cash, you face a big decision; whether to use that money to pay off or pay down debt or to invest it. The decision is far from simple. While most financial advisors would recommend that, if your after-tax return on investments is greater than your after-tax cost of debt, you should invest, you’ll also need to take into account the risk of any potential investment. Unless you invest wisely, you could end up even further in debt.
While remaining in debt adversely affects your credit rating, and can be a bit of a slippery slope that can leave you bankrupt, financial advisors stress the need to look at your complete financial picture (in which building a nest egg is a major part). In other words, both staying out of debt and planning for the future are important.
Financial advisors suggest you maintain at least six months’ worth of monthly expenses in either cash or a checking account. Once you have that cash cushion in place, you can start to think about paying down debt. Advisors suggest a monthly debt-to-income ratio (DTI) of no more than 25% to 33% of your pretax income.
Investing for the future
While savings plays a part, it’s the growth portion of your portfolio that will play the biggest role in ensuring that you are able to retire when and how you want to. Investment income comes in the form of interest, dividends, and asset appreciation. Investing can also help you with other financial milestones such as paying for your kid’s education, or starting a new business. A dividend earning portfolio is also a good counterweight to any emergencies that might arise.
Debt, on the other hand, is the act of borrowing money (usually with interest paid over time) to finance a large purchase such as a home or car. These kinds of purchases are unavoidable for most people as these things are essential to everyday life and most people don’t have the cash to purchase them outright (if ever).
But if you’re like most Americans, debt faces you down every month in the form of your credit card statement. While it can be tempting to pay just the minimum amount each month, this is not a strategy that a financial planner would recommend. According to a survey from CreditCards.com, 47% of Americans are carrying credit card debt, to the staggering tune of 1 trillion dollars at the start of 2020. And this situation has only gotten worse as a direct result of the Covid-19 pandemic. If, like 40% of Americans, you can’t pay more than the minimum each month, it may make sense to use any extra money you acquire to try to pay your cards off. Financial advisors caution that, only then, should you look into using those funds for additional investment.
If you’ve ended up at the end of the month with more than you expected, congratulations. Ensuring that these windfalls occur on a regular basis is the goal of good financial planning. The decision on where to put your extra cash will depend on your income, budget, and goals. Whether and how to invest is based on your risk tolerance. Doing things in the right order may help you put that extra cash to work for you faster.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.