Not sure whether to pay off a debt or to invest money instead? Laura covers the main pros and cons and shares a simple method to prioritize your precious resources so you accomplish key financial goals and build wealth as quickly as possible.
One of the most common financial dilemmas is whether to use spare cash to pay off debt or to invest. It’s important to accomplish both, but with only so much money to go around, how do you know which to focus on first? If you’re not sure about the next move to make, it’s easy to feel stuck and never make progress with your personal finances.
In this post, I'll cover the main pros and cons of paying off debt before investing. Plus, you'll learn a simple method to prioritize your precious resources so you accomplish key financial goals and build wealth as quickly as possible.
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First Understand the Big Picture of Your Personal Finances
Too often we get bogged down by a specific financial decision or dilemma without considering the big picture. To make the best decisions, it’s wise to step back and take a holistic view of your entire financial life.
I created a simple, three-pronged approach called the PIP plan, which stands for Prepare, Invest, and Pay Off. Use it as a touchstone when considering how to allocate your money wisely.
1. Prepare for the unexpected.
Life is full of surprises and many of them drain your bank account! So before spending a dime on debt or investments, ask yourself if you’re really prepared for the unexpected.
In an instant, you could lose your job, see your business income dry up, get a serious illness, lose a spouse, or experience a natural disaster. It’s not fun to think about these types of devastating situations, but they happen.
In an instant, you could lose your job, see your business income dry up, get a serious illness, lose a spouse, or experience a natural disaster. It’s not fun to think about these types of devastating situations, but they happen every day.
While no amount of money can reverse a tragedy, having a financial safety net can make it so much easier to cope. What you need depends on factors such as your living expenses, debt payments, income, and whether you have dependents.
At a minimum, strive to maintain an emergency fund equal to three to six months’ worth of your living expenses. For instance, if you spend $3,000 a month on essentials (such as housing, utilities, food, and debt payments), make a goal to keep at least three times that amount, or $9,000, in an FDIC-insured bank savings account.
If accumulating that much money seems out of reach, don’t worry. Just get started with a small goal, such as saving $500, then $1,000, until you have at least one month’s worth of security on hand.
Having even a small cash reserve is better than nothing because it can keep you from going into debt in the first place if you hit a rough financial patch (and who hasn’t?). In Should You Invest Emergency Money or Keep Cash, I cover more about how to calculate how much reserve you need and the best places to keep it.
Another key way to prepare for the unexpected and stay out of debt is to have the right kinds of insurance. Being underinsured or uninsured means that a disaster, theft, or accident could wipe out everything you’ve worked so hard to earn and jeopardize your entire financial future.
For starters, if you drive (even if you don’t own a car) you could hurt someone and get sued for expensive injuries and medical payments. And having just the minimum amount of liability oftentimes isn’t nearly enough. For instance, in Florida you’re only required to purchase $10,000 in auto insurance liability. If you were found guilty for injuries totaling $100,000, you’d be on the hook for the balance of $90,000.
Then there’s homeowners and renter’s coverage. If you have a mortgage, lenders require home insurance—but most renters go uninsured, which is a big mistake. Renter’s insurance is a bargain for the protections your get, costing less than $200 per year on average. Just like a homeowner’s policy, renter’s insurance covers some amount of your personal belongings, liability, and living expenses if you’re forced to move out after a disaster.
The more income and assets you have, the more coverage you need to stay safe. Consider adding an inexpensive umbrella liability policy for additional protection above and beyond what you get on your auto and home or renters insurance.
See also: 5 Ways to Save Money on Car Insurance
And no matter what does or doesn’t happen to the Affordable Care Act, everyone should have health insurance to protect your finances. All it takes is one visit to the emergency room or a short stay in a hospital to rack up a massive medical bill that could turn your financial world upside down.
All it takes is one visit to the emergency room or a short stay in a hospital to rack up a massive medical bill that could turn your financial world upside down.
The last insurance I’ll mention is life insurance. It’s a must for anyone with family who would be hurt financially if you died. You can protect loved ones with inexpensive term coverage that may not cost more than $200 a year for a $500,000 benefit, if you’re in relatively good health.
You can get free quotes for any of these types of insurance using sites like insuranceQuotes.com or netQuote.com. The key to getting the best deal is to shop and compare quotes from multiple insurers.
The bottom line is that if you don’t have an emergency fund and don’t have insurance that’s critical for your and your family’s safety, you’re not ready to pay off debt ahead of schedule or to invest.
The only exception would be to pay off any dangerous debt you may have, such as overdue child support, tax liens, and accounts in collections. These can wreak havoc on your financial life, so they need to be addressed as quickly as possible.