Whether it is a credit card, student loan, car repayments or a mortgage, most of us have some sort of debt. Although this seems to be how the world works these days, keeping on top of such heavy financial burdens can be quite involved, and can even make you feel powerless if the debt gets too heavy. But with the heavy conventional wisdom in favor of investing (typically in retirement accounts) as a priority over all other financial activities, it could open up the question, pay off existing debt or invest the money elsewhere?
But even though these ever-present obligations allow you to live a comfortable life, things might change in the future. It is a sensible idea to have some money saved away for a rainy day or your inevitable retirement. And when this is brought into consideration, your existing debt doesn?t seem so imperative after all and investing any spare money you may have becomes the more alluring option.
Or does it?
Managing Your Money
Prior to any sort of investment, you have to take a close look at your current financial situation, especially your debts. High-interest debts such as credit cards should ideally be paid off as soon as possible, as the long-term consequences can be catastrophic. You could be charged a penalty fee for late payment, receive a poor credit rating and the interest rate might go up even more.
I?ve often pointed out that matching an uncertain return of 10% in the stock market with the certainty of a 10% interest rate charge on a credit card is a bad tradeoff. After all, the return on stocks is hardly guaranteed, regardless of the fact that it may seem to be – more than five years into the current bull market. Rest assured that is isn?t. Worse, you can lose money in a market fall, and not all declines will necessarily reverse themselves as quickly as Wall Street cheerleaders claim.
Other types of debt, such as a student loan or mortgage, tend to be at a lower interest rate. These are what we might think of as patient debt, in that it?s long-term in nature, and fixed in regard to both term and payment. With this kind of debt, it makes sense to invest for growth while you are gradually – and predictably – paying off your debt.
The best approach is to come up with a budget or spending plan so that you?ll be able to both save and invest money, while paying off debt. That way you?ll be able to improve your credit rating and find out whether you even have enough money to invest. Along with investing, you should be able to pay more than the minimum on your debts.
Rates of Return, Interest Charges and Taxes Matter
Any investment could be null and void if the rate of the return is lower than the interest on your debts. It may feel like you?re making money, but you?ll actually be losing it from greater interest charges on your debt. Not every investment is guaranteed to make a determined amount every month or year either, so there is also an element of risk involved too.
We just discussed the imbalance between the return on stocks vs. the interest charges on credit cards being unbalanced – even if the rate on the cards is comparable to the historic average rate of return on stocks. But if your credit cards have in interest rate above 10% (roughly the long-term average return on stocks), investing money while carrying large credit card balances will be a guaranteed money losing strategy. You?ll need to first focus on paying off your credit cards before you consider investing in risk assets of any kind.
It should go without saying that if your credit cards have a default rate of interest (generally well in excess of 20% per year), there will be no point to investing at all.
On top of that, you?ll have to think about tax implications. Investment earnings may be taxable, while the interest on your debt may or may not be tax-deductible. Mortgage debt, being generally tax deductible (but don?t always be certain of that either) may be the lone exception.
Credit card debt carries no such tax deduction, making another compelling reason for paying it off before you begin investing.
Only Invest When You Know Your Debt Won?t Catch Up With You
There is every chance that the money you earn through an investment will be more than the interest on your debt too. But you have to keep a careful eye on the quality of your investments. Though you should be fine with mutual funds, exchange traded funds, or blue chip stocks, you should be careful with lower grade individual stocks you may want to own.
Even more so are stocks in small companies, such as what are now being offered through cloud funding arrangements. Before investing money in such securities – especially if you also have debt – you should do a thorough investigation on any company you plan to invest in. There are excellent companies you can do this through, such as DueDil. Never rely on the strength of a company solely because it has been recommended by an analyst or investment advisor, or because it ?looks? like a good investment.
If you?re absolutely sure that you?ll receive a higher after-tax return on investments compared with the after-tax interest rate expense on your debt, then it might just turn out to be a good long-term strategy.
I realize that most people – five years into a bull market in stocks – would suggest that you begin investing for retirement before paying off debt, as though it?s some sort of holy mission, but I can?t agree. You can still lose money in a tax-sheltered retirement account, and still have debts to pay. When you add that to the fact that paying off debt will increase the monthly cash flow you have available to save for retirement, it seems that paying off credit cards – at a minimum – should be a required first step.
What do you think? Pay off debt or invest first?
My vote is firmly on the side of ….both. I know Dave Ramsey, whom I really do like, prefers you pay off debt first and then invest, however, it is quite possible to do both. The debt doesn’t get paid off as fast, however, you don’t lose all those months or even years, of compounding earnings when you have nothing in investments. So I’d take whatever money I allotted to this purpose. Split it in half and watch the debt figure go down as the savings/investment figure went up. Win win in my opinion.
Hi Kathy – I see your point, but you can only do that if you have the cash flow to do both. A lot of people have to prioritize. I think that the more threatening your debt is, the more imperative it is for you to pay it off first. It’s like clearing the decks so you can move on to the next big adventure. In the households where money is tightest, debt is usually a major problem. The sooner it’s gone the better off you’ll be. If you have to choose one or the other, my money’s on tackling the debt first. Thanks for weighing in!
Hi, Kevin
You have an excellent point about prioritizing. My point of view came from when I was paying off debt with no savings. I’d make huge payments on the debt but then something would come up and I’d have to put a dental bill or auto repair bill on the credit card because I’d used all my cash to make debt repayments. It was a never ending cycle. So I do agree about paying off the debt first with the caveat that you have a nice emergency fund established. That way you aren’t constantly chasing your tail.
Hi Kathy – That’s an excellent point! The true priority would put saving an emergency fund first. In order to make any progress financially, you first have to get liquid. That means establishing a source of ready cash for just such emergencies. Otherwise you’re always “robbing from Peter to pay Paul” as the saying goes.
I didn’t have a lot of debt and it almost kept me from some great opportunities, so in my opinion: debt comes first and then the rest.
Hi dojo – I agree. I’m a big fan of traveling light in life, and debt weighs you down. When you pay it off, it frees you up and opens a lot of options. We all need that freedom and those options to have a good life, so my money is on the debt payoff (with an emergency fund as a starter).
I land in the middle. My priority would be to fund an zero interest emergency account with at least six months of expenses before paying down down or investing.
We do not know what is around the corner. A sudden job loss or disability could turn your plans upside down instantly. Most people overlook these common pitfalls, or just assume them away.
If you pay down debt too aggressively you leave yourself no wiggle room. If you invest you lose needed liquidity.
I completely agree Kevin. The debate in the post is payoff debt OR invest first, but what I should have noted was that both should come only AFTER setting up an emergency fund. I’m a big proponent of emergency funds, and I’ve written about them in other articles on this site and others. No idea why that escaped me here!
Very good article. I wonder though, would it be a good strategy to use a Roth IRA like your emergency fund? The money can be taken out anytime (up to contribution around) if something unforeseen does come up. Meanwhile, it is earning returns, hopefully.
That’s a possibility Jack, but I’m of the opinion that a Roth IRA should be used for its intended purpose, which is retirement. If you use it as an emergency fund, then it becomes like an ATM, and you might end up draining it for purposes that fall well short of an emergency. But I’ve heard a lot of sources advocating a Roth IA as an emergency fund so you’re not alone in that thinking.