Should you save, invest, or pay off debt?
It's the magic question: what should you do with your spare cash? Most of us know that debt is a four letter word, but is it always sensible to pay it off? Stocks and property will almost certainly outperform cash over the next 20 years, but what if you only have a few years to invest?
Before we get to the nuts and bolts, it's important that you always maintain some easily accessible cash to act as a buffer should any unexpected expenses arrive. If you use every last penny to invest or pay off debt, it could put you in a position where you rack up even more costly debt or overdraft fees if you run into trouble, such as the loss of your job.
A good rule of thumb is to have enough savings to cover at least 3–6 months' worth of living expenses (and never invest money in the share market you will need to access within the next 5 years). If you're young and have parents who will come to the rescue, you may be able to get away with something at the lower end of that range, but if you have dependents of your own or work in a cyclical industry with little job security, you should aim for a larger emergency fund.
Park your emergency money in a high-interest savings account or, even better, a mortgage offset account because the interest saved is likely to exceed the interest earned elsewhere.
Interest rates
Speaking of interest, after you've put aside some emergency cash, deciding whether to invest or pay off debt ultimately depends on the interest rate and yield.
If you have any high-interest debts, such as credit cards and personal loans, paying these off should be your top priority. Paying off a credit card that charges 20% in interest is the same as getting a 20% return on your savings, which would be hard to match even by investing in stocks or property.
But some debts may be worth keeping. For example, a HECS-HELP student loan charges no interest and has no fixed term. It's probably the best loan you will ever get. There's a case for keeping this debt for as long as possible and making only the compulsory repayments, so you can invest the capital in higher yielding assets.
If you have a mortgage that charges 5–6% interest, though, deciding whether to invest or make extra repayments is a harder call. Making extra repayments on a home loan that charges, say, 5% means you're effectively getting a 5% return. It's also tax free, so if your marginal income tax rate is 30%, that 5% saving is the same as a 7% return from stocks.
The stock market has returned around 9% a year over the long haul, so – on the face of it – it still seems better to invest your extra cash in stocks. But once you take into account that paying down your mortgage is a guaranteed return, while stocks are volatile and at historically high valuations, the decision isn't obvious.
The answer is probably to do both – continue paying off your mortgage, but don't neglect building a nest egg of other assets, which reduces risk through diversification. If several assets or debts offer similar after-tax yields and interest rates, it's better to spread your bets to protect you from poor performance in any one asset class.
Learn before you leap! If you are considering investing for the first time you should try our InvestSMART Bootcamp. It's an instructor led course, all online designed to teach you the basics of investing so you start on the right foot.
Frequently Asked Questions about this Article…
It depends on the type of debt and the interest rates involved. High-interest debts, like credit cards, should be paid off first as they offer a guaranteed return equivalent to the interest rate. For lower-interest debts, like a mortgage, consider a balanced approach by both paying down the debt and investing in diversified assets.
It's recommended to have an emergency fund covering 3-6 months of living expenses. This ensures you have a financial buffer for unexpected expenses, reducing the risk of incurring more costly debt.
Both options have merits. Paying off your mortgage offers a guaranteed return equivalent to the interest rate, while investing in stocks can potentially yield higher returns but comes with more risk. A balanced approach of doing both can help diversify your financial strategy.
An emergency fund provides financial security in case of unexpected expenses, such as job loss or medical emergencies. It prevents the need to rely on high-interest debt, which can be costly in the long run.
Park your emergency savings in a high-interest savings account or a mortgage offset account. This way, you can earn or save more interest compared to other savings options.
Yes, since HECS-HELP loans charge no interest and have no fixed term, it's often beneficial to keep this debt and invest your capital in higher-yielding assets instead.
Interest rates determine the cost of debt and the potential return on investments. High-interest debts should be prioritized for repayment, while lower-interest debts can be balanced with investment opportunities for better financial outcomes.
The InvestSMART Bootcamp is an online, instructor-led course designed to teach beginners the basics of investing. It's a great way to start your investment journey on the right foot.
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