Got extra money? Pay off your debts or save and invest it

Editor’s note: This article was first published in October 2011. Example 2 relies on Spain’s income-tax deduction for buying a main home, which was abolished for purchases from 1 January 2013, so the advice not to pay off a mortgage for tax reasons may no longer apply.

Sometimes a person comes into some extra money, whether from an inheritance, a lottery prize or savings built up over time that are now available. Faced with the question of whether it’s better to use that money to clear our debts or to save and invest it, the default answer would be to pay off the debts. But depending on the case, that isn’t always the best choice, because there are some details to analyse. Let’s look at a few examples.

To start with, if the plan is simply to take the extra money and leave it sitting in a current account, you’d be much better off clearing the debts that are charging you interest. It’s a different matter if you plan to invest the money instead of paying off the debt, because then the point is to find a way of earning a positive return on your money that is higher than the interest the debt costs you.

In other words, if we’re paying off instalments at 2% interest, it might be a better idea to invest the money in search of a higher annual return, which would give us a gain we couldn’t get if we cleared that particular debt.

Example 1: pay off the debt or invest?

We have a credit card with a debt of 3,000 euros. We receive an extra 2,500 to 3,000 euros. In this case, don’t think twice: pay off the credit card, because you won’t find an investment capable of beating the interest the card charges you. In this article we explained how credit cards work, and in this other one, the types of credit cards.

See also: Will you be giving children financial education classes at school?

Example 2

You have 15,000 euros left to pay on your mortgage and you receive an extra 20,000 euros. In this case, you should sit down with an adviser to find out how losing your home-purchase deduction would affect your income tax return.

In many cases, given the tax benefits of paying for a home, it wouldn’t pay to clear that debt. You could use the money to earn a return instead, and you’d still be able to claim the deduction on your home. You need to look at the interest rate you pay on your mortgage and at what you’d actually deduct with it and without it. No one will answer better for your personal situation than an adviser.

The psychological factor: a reason to save the money instead of clearing the debt

Another factor to consider is the psychological one: having a financial cushion for future problems is not the same as knowing that you couldn’t cope with a financial setback.

There are cases of people who financed themselves by creating their own debt, even selling their home to move into rented accommodation and investing the proceeds in various products or in a business. It must be said that it worked out for some, while others didn’t plan their strategy properly and, three years later, found themselves without a home and with less capital.

I know some people will think it’s crazy to sell a home in order to invest in anything at all. But bear in mind that it’s very hard to get an attractive return on 3,000 euros of capital, whereas with 200,000 euros you can work wonders and earn a return that more than covers the rent. It’s a way of putting your money to work, since a home on its own doesn’t work for you, unless it’s an investment property intended for that purpose. But that’s another story.

Still, debt isn’t always bad: many great businesses have been built on debt. You just have to distinguish between healthy debt (financing, growth) and bad (toxic) debt.

Where I come from, there’s a saying: “He was so poor he didn’t even have debts.”

Featured image: Ricardo Martín, Public domain, via Wikimedia Commons.