Investing vs Paying off debt, which one should you do? This is a very interesting subject to me, especially because the answer is a very personal one, what is better for me might not be the best for your situation. The problem is that if you ask this question to a super Frugal saver, they will always answer “Pay your debt”, and if you ask the same question to an Investor, the answer will probably be “You have to invest NOW!”. Honestly, “to a man with a hammer, everything looks like a nail” and that is the wrong approach.
Relevant posts: If you want to learn how to Invest in stocks, make sure to give this post a read: How to become a badass investor in 5 steps, or you could learn how to turn $100 into $500,000 with dividend stocks
Investing vs Paying off debt: The Dilemma
There are 2 critical factors that will determine your course of action. These factors are: Debt Interest Rate and How much debt you currently carry. When considering debt, not all debts are the same, some are really bad, while some others are good (I should say, not so terrible).
A good debt is one that most of the times we have to incur in order to achieve something, as in, this kind of debt is almost unavoidable. A mortgage, car loan or a student loan are usually considered “good debt” and the reason for is simply the associated interest rate. The interest rate for a mortgage is currently under 5%, for a car loan is 5%, and for a student loan would be under 8%.
Since the interest rate is so low, your interest payments will not eat a huge chunk of your money, as long as you keep that debt at a manageable level of course. What I mean is that while you will pay only 5% or less on interest rate for your new shiny brand-new car, you shouldn’t pay 50% of your monthly income for that car! Keep your debt within your means!
If you mostly have good debt, and is at manageable level, then you should start investing and paying your debt at the same time. Focus on paying your student loan as soon as possible and if you can pay more than your monthly payments, do it, it will save you quite some money on the long run. Why your student loan first? Because it has the biggest interest rate ;).
This is an easy one, the worst kind of debt that you can carry is a credit card debt! Avoid credit card debt like there is no tomorrow, and if you have to carry a balance, please do yourself a favor a look for a low interest rate card, I don’t care that on your current credit card you are collecting miles, getting cash back or any other shiny perk, get rid of it now!
The interest rate for a credit card on The United States of America is 24.99% and in Canada is 22.99%, that my friend is A LOT. Consider this example: You have a credit card with a $5,000 balance, your interest rate is 24.99% and your monthly payments are $200.
At the first year, you would have the following balance:
12 Payments of $200 each: $2,400
Current Balance: $3,963.40
Interest paid: $1,125.81
Principal paid: $1,036.60
If you keep paying $200 until you get rid of your debt, it will take you exactly 14 years and 1 month and $5,183.12 in interest for a $5,000 loan. That is insane!
If you instead move to a 7.99% credit card without those shiny perks. You can still pay only $200 a month, and it will take you instead 8 years and 7 months to service your loan, costing you only $960.17 in interest! I prefer saving the $4,200 in difference and cover the shiny perks myself.
It’s all about the gains! (or returns)
Personally, what helps me decide if I have to focus only on paying my debt, or if I can Invest while paying my debt is how much I can benefit from doing one or the other. When Investing, specifically in the Stock Market, the average annual return is of 7%, which should be the basis of your calculations. Side note: you can potentially earn more than 7% when you move from index investing or mutual funds to picking your own stocks, this is what legendary investors do! You can learn the basis of this strategy here.
Where to draw the line?
I draw the line exactly at 7%, if any of my current debts has an interest rate higher than 7%, I will focus on paying that debt before investing. By focusing on paying your high interest rates you are effectively making money, how? Well, think about the previous scenario of a credit card with $5,000 at a rate of 24.99%, by paying that debt you are guaranteed to save $5,183.12 in interest, which you can use to invest in stocks!
Exceptions to this rule
1- You have to develop a new habit:
Lets start by stating the obvious, I’m heavily biased toward investing! I personally believe that you still have to invest while carrying debt, and the reason is simple: you have to develop a new habit. If you plan to invest while carrying debt, you have to do it in a conservative way, this is, focus heavily on paying your debts while still contributing a small portion of your income to investing and creating an emergency fund. I calculated using real data that if you invested only $100 monthly in the stock market since 1981, you would currently have over $500,000. This is the reason you have to create that habit my friend.
2- You don’t have an emergency fund:
If you don’t have an emergency fund, you have to focus right now on creating one. The whole purpose of an emergency fund is that, for an emergency. If you don’t have money saved for any eventuality, you will be forced to use your credit cards to pay for those events, which will put you back to carrying debt. Or on a worst case scenario, you lose your job, you need to have funds to cover your mortgage/rent, utilities, food and basic services for at least 3 to 6 months, this will help you keep your sanity while searching for a new job.
3- Your Debt to Income Ratio is over 35%
If you pay more than 35% of your income in debt, you should consider putting your efforts on lowering that ratio. In example, if you earn $5,000 a month and pay more than $1,750 in debt, you should focus on lowering your debt. To do this, there are 2 options, either you contribute more to your debt payments, or you find a way to increase your income. I would advise you to do both, and trust me, I know it can be scary to ask for a raise or look for a new job, but think about how much that fear is costing you right now?. If you are going through these thoughts right now, I will share my mantra that I repeat every time fear takes over: “Thank you fear for being so thoughtful and trying to protect me, but asking for a raise/getting a new job will not kill me”
I hope I helped you to decide if you should focus only on paying your debt, or paying your debt while investing at the same time. Once you got rid of your high interest debts, you can the start investing aggressively in stocks!