Paying Off Debt Versus Investing

When people find themselves with a windfall or even additional long-term income, their first impulse might be to have some fun. They may buy a new car, go on vacation, or finally build out that man cave, game room, or yoga retreat they've been dreaming of. After all, the old adage about a life heavy on work and lean on play still holds true. 

But since most adults are stuck with a situation in which they 1) hold a lot of debt, and 2) have to plan for their own retirement, it pays to be responsible when it comes to allocating extra income. Although you may be tempted to go nuts with your fun money, the truth is that it could certainly be put to better use paying down debt or investing in your future. But which one is right for you?

There are several things to consider before you decide where to funnel your funds. Since you probably hold plenty of debt already (and retirement is a long way off), let's start by looking at what you can accomplish by paying down debt. The main thing to consider with any debt (home, car, and student loans or even medical bills and credit cards) is interest. And if your interest is high, you need to focus on paying down the debt. The reason is that the longer you carry debt, the more interest you rack up. This could drastically increase your debt over time (to double or triple the initial cost of purchases...or even more). So cut up your high-interest cards and pay them off post haste!

As for other common types of debt, such as a home loan, you need to stop and consider how much you'll spend over time if you continue to make regular payments (as opposed to paying more each month on the principle) versus how much you stand to earn in interest by socking away your money in a 401K or Roth IRA. In most cases, investing will prove a better bet. Here's why. Retirement accounts run on compound interest, which means you're not only earning interest on the money you contribute, but also on the interest you've already earned. So even if you put in money early, then stop contributing and just let it sit, it will continue to grow. You'll end up with more at the age of retirement than if you start contributing later, but end up paying in longer.

In addition, funds that go into your retirement accounts fall under the category of pre-taxable income (up to a certain amount annually), which means they're tax deductible. Interest payments on your mortgage are also tax deductible, so continuing to pay the monthly due on your home loan (rather than paying more towards the principle) will extend the number of years you can claim this deduction. 

And it's not like you're investing in hot technology penny stocks that could ruin you just as easily as they could pay off; retirement accounts are considered some of the safest investments around. Ultimately you will have to look at your financial situation to decide which spending scenario is most beneficial to you. But either one is better than blowing your dough on a new TV or a day at the ballpark.