In today’s tight economic climate, many people wonder what is the best method of improving their financial position. We read that we should make our money work for us but worry about making a wrong decision that could actually cost money rather than make us money. In this article we will look at the pros and cons of saving and investing, as well as reducing debt, as a means of gaining financial security.
If you are pondering this question, you probably have access to some spare cash; otherwise you wouldn’t be considering either savings or investment. So, your question could well be – “What should I do with my spare cash to get the best return?” When I found myself in this position a few years ago, this was the question I asked myself.
What Is Saving?
Saving means that you deposit a sum of money, which you can generally add to over time, into an account with a bank, credit union, savings and loan or other financial institution. The bank uses your money for lending and pays you a pre-determined interest rate for that privilege. You can be confident that your original cash deposit amount will be available to you whenever you need it, along with any interest that has accrued. Even if a bank goes bust, the least you can lose is the interest; your own money will be safe. The down-side of this method is that interest rates are usually quite low so the amount your money makes for you is small.
What Is Investing?
Investment in the stock market seems to be attractive at the moment because stock prices are still low, which means that investors can buy more shares for their money. For investors who are looking at the long-term, this could be a viable option, as the stock prices will invariably rise over time. If you want to get your cash back, you need to sell your shares; the price of your company’s stock may have gone up and so you will make a profit. Conversely, the price may have dropped and you can only sell them for less than you paid for them. In effect, you will lose money because you won’t get back the amount you originally invested. This potential for loss is the major difference between savings and investment. The rewards are potentially higher with investments but so is the risk of losing your money.
If you decide to invest in real estate, precious metals or collectable items, the same situation applies as investment in the stock market. The potential for good returns exists but so does the possibility that you will lose money.
What About Debt?
The chance viewing of an interview on TV gave me a third option – that of using my cash to pay off my debts, especially high-interest debt. It sounded like a strange suggestion as a means of improving one’s financial position but I soon came to realize what good advice it was. By throwing my spare cash at my high interest credit card debt, I would be saving money by reducing the amount of interest I would have to pay. A dollar saved, as they say, is a dollar earned.
What Should You Do?
To check whether this is the best option for you, you need to know what after tax interest rate your debt is costing you. Then you compare that with the rate you would expect to get from investing or saving your money. If you can earn more interest from your investment, then this is the way to go but if you will save more in interest by paying off your debt faster with your spare cash, you should do that. This tactic will generally work best with high interest debts like credit cards rather than lower interest loans like mortgages.
If you have several credit card balances, accruing high interest, start with the most expensive one and get it paid off first. If they all have similar interest rates, start with the smallest balance and pay it off. Then you can throw the money you used to pay that one off at the next smallest balance, until it is also paid off. This strategy is called the snowball effect and allows you to pay off each balance and then put extra money into paying off the next one.
You might really want to start some investments but you owe it to yourself to do what is best for your financial future. Cash is king in today’s climate and every dollar you save in interest on personal debt is effectively a dollar you have paid to yourself. Your long-term financial plan should include being debt-free (because it is a constant drain on your finances) in conjunction with a lucrative investment portfolio, which is steadily increasing your wealth.
What do you do? Save or invest?
For a long time I was in savings mode but now I am in investing mode. The low interest rate really hurts your savings and you are actually loosing out against inflation.
Agreed. Right now investing is the way to go. I know for us we still need to do some savings but investing is our top priority right now.
Nice post. I think a lot of it comes down to your personal situation as to what is best. We’re just getting to the point of being in the investing mode. We already have IRA’s, but are looking to branch out from there as a hopes to earn more than what you can saving…which is not really that difficult these days.
We are similar. Interest rates are so low right now that saving doesn’t get you very far. We are working on boosting our investments to see if we can get some decent returns. It’s true though, everyone has a different situation. I think stage of life is a big factor.
I save money for my short term goals and invest it for my long term goals. If it is less than a year away the money is likely in my savings, not my investment, account.
That is what we do too. It sucks to have to pay fees for releasing the money after a short time. I really like TFSA’s. We have them in Canada. They are a great way to boost your short term savings.
Nice philosophy = pretty much sums me up!
If it’s a question between saving and investing, I think it is more financially beneficial to invest your money, but if you’re the type of person who is afraid to take risks and wants to make sure that you can get your money any time you want it, then saving is the right one for you.
True. There are some people who don’t want to take any risks. The issue with this is you end up losing against inflation which is why you need to do some investing to off set that.
One difference between “investing” in your debt and investing in stocks: When you pay off debt, you earn a guaranteed, risk-free pre-tax rate of return equal to the debt’s APR. When you invest in stocks, etc., you don’t know what your return will be and your principal is at risk.
Personally, I’d choose to invest in any debt I had with an APR over, say, 3.5%-4% before I’d invest in stocks in today’s climate, but that’s just me and is a function of my age and circumstances. At other points in my life I would have made a different choice.
Stage of life is definitely a factor. As a young couple we invest differently than we will when we are middle aged. Interest rates also dictate. If the interest rate you are paying is higher than what you are making on investments, then debt should be the number one thing to deal with.
It’s all about investing for me! I take more risk than most would advise – I have my down payment money invested in a 60/40 bond/stock fund, with roughly 3-5 years to go until I’ll be ready to buy a house. Once I’m within a year or two of buying a house, then I’ll probably move that into savings.
The only thing I have in savings is my emergency fund.
Interesting approach. If it is working for you then that is great. I can definitely see the interest gains you are getting compared to a basic savings account.
If you have high interest debt it’s a no brainer to pay that off first. After that I’d recommend investing. Saving results in little progress.
The fact that interest rates are so low on savings accounts these days does hurt the progress you can make in shorter time.
I save. I think (from experience) that having an emergency fund, even before paying off debt, is the first step. Anything after that, I still save. I’ll start investing when I graduate and have a job that offers me that option via a retirement account.
I would agree. You don’t want to go into more debt because you can’t cover an emergency.
Yup – pay down high interest loans first, leave the mortgage unless you are paranoid about being able to pay it and build a portfolio that is balanced between property, shares, bonds and other investments etc. You may need to have some liquid funds or just have a line of credit. Leaving money in the bank just makes them richer. You have to calculate how much you need in the first place because life is not for saving, spending or investing but for living.
I love your last line. We definitely need to figure out what we need to live the life we want. I do agree with leaving the mortgage until last and invest instead. Your gains are typically much higher.
We are in the process of paying off loads of student loans.
(Sorry, I accidentally hit publish too soon!) By paying down student debt, as you say, we are saving ourselves money. Our goal is to be debt-free eventually.
I think that is a wise approach. The shorter time you can pay interest the better off you will be.
I invest pretty aggressively and believe my 30s are a good time to do so. I have a month worth of expenses in cash and could always cash out some investment at a loss in case of a big emergency. But I want to try and grow my net worth right now and am willing to take risks.
Interesting plan. I can see the advantages. I think the only caution is to make sure you can cash out your investments fast if you need and that they are not locked in. Otherwise you could run into trouble.