So, you owe some money. Whether it’s credit cards, school loans, or a car loan (or all three), you know you need to pay off your debt. At the same time, investment opportunities seem so attractive, particularly if your employer matches 401k contributions. You only have so much money to devote to either one, so what should you do? Is investing a smart idea while you’re still in debt?
One option: you can pay off your debt in its entirety before investing. On the flip side, you can make only the minimum payments on your debt while investing the rest of your money right away. Both paths have their pros and cons.
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Arguments Against Investing While In Debt
1. Debt Often Adds Up Faster Than Wealth Does
The number one argument against investing while in debt is that debt tends to accumulate at a faster rate than does wealth. From 2006 to 2015, the S&P 500 Index experienced an annual return rate of 7.25%.
While that sounds great, debt tends to come with an even higher interest rate. The average credit card interest rate in 2015 was 12.09%, with penalty interest rates being as much as 29.99%.
With these figures, it’s simple to see that investing while in debt will only put you further behind if it comes at the expense of paying down debt more slowly. You will end up paying more in interest charges than you will receive in investment returns.
2. You’ll Have More Financial Freedom If You’re Debt-Free
Having debt payments as a constant part of your finances can restrict your ability to use your money for other, more exciting things. Let’s say you come across an incredible investment opportunity, perhaps a great deal on a rental property in a booming area. It may be an excellent opportunity that would profit you for many years to come, but if your money (and credit) is tied up in debts, you will have to watch that ship sail.
For this reason, some argue that you should first focus solely on paying off your debts. This will free up your cash flow faster than if you were to invest while in debt.
3. It’s Better To Have No Debt In The Event Of Job Loss
Unexpected job loss is one of the worst things that can happen in terms of finances. It puts a sudden stop to your paychecks, which most people depend on to meet their monthly obligations. Simply put, it’s better to eliminate your debt in case of an unexpected job loss. In the unfortunate chance that you lose your job, you could cut back on certain areas in your budget like groceries and subscriptions. It’s much harder to cut back on your debt payments.
For example, you can’t just decide not to pay your car loan, or else you’ll lose your car. If you don’t pay your credit card bill, you’ll incur additional interest and have to pay more in the future anyway.
Given this reasoning, it makes sense not to invest while in debt. Instead, paying off debt first will be more beneficial. In the event of a job loss, not having debt will mean one less thing to worry about.
How To Pay Off Your Debt Quickly So You Can Invest
If you want to invest but are convinced that you need to pay off your debt first, you may be looking for the most efficient way to pay down your debt. In the personal finance world, there are two main ways to pay down debt: the debt snowball and the debt avalanche methods. Both methods have their merits. Which you choose ultimately comes down to your personal circumstances and preferences.
Debt snowball method
- List your debts in ascending order by amounts owed, from the smallest to the largest.
- List the minimum payments for each debt.
- Pay only the minimum payment for all of your debts except the smallest one.
- Put all of your extra money towards paying off your smallest debt.
- When your smallest debt is paid in full, repeat the process with the next smallest debt until you have paid off all your debts.
The main benefit of the debt snowball method is motivation. By focusing on eliminating one debt at a time in its entirety, you’re giving yourself one less bill to pay. This small accomplishment will motivate you to take the next debt head-on and eliminate it too.
Debt avalanche method
- List your debts in descending order by interest rate, from highest to lowest.
- List the minimum payments for each debt.
- Pay only the minimum payment for all of your debts except the one with the highest interest rate.
- Put all of your extra money towards paying off the debt with the highest interest rate.
- When the debt with the highest interest rate is paid in full, repeat the process of paying the debt with the next highest interest rate until you have paid off all your debts.
The main benefit of the debt avalanche method is that you save money on interest. By tacking the debt with the highest interest rate, you minimize the amount of interest you’ll pay in total. You’ll also get out of debt faster this way since you will end up paying less altogether than if you were to use the debt snowball method.
Either way, one should always look into the possibility of refinancing debts. Depending on the type of debt you hold, you may be able to work with your lender, or a new lender, to get a lower interest rate or even consolidate. This has many benefits: a lowered interest rate means less money out of pocket in the end as well as getting out of debt faster.
Arguments To Invest While in Debt
1. Compound Interest Works Best When You Start Early
The earlier you invest, the more money you will have in the long run. This is because of compound interest. Put simply, compound interest is the accumulative effect of investing over time. It is the interest you earn on your original investment plus the interest earned on the interest that accumulates on your original investment.
Here is an example that demonstrates the power of compounding interest. Suppose you invest $10,000 in an exchange traded fund with an annual return of 7.25%. You expect to withdraw the funds in thirty years. After the first year, you’d earn $725 in interest giving you a new balance of $10,725. After the second year, you won’t earn $725 in interest like you did the first year. You’d earn 7.25% on your new balance, which is $10,725. That means that after the second year, you’d have $11,502.56. Fast forward 30 years later; you’d have $81,643.01 (compounded annually).
Now suppose you invest the same $10,000, but five years later. With the same withdrawal date, that gives you 25 years for your money to grow. After year 25, you’d have $57,535.05. That’s a difference of over $20,000!
As you can see, investing early generates much more compound interest. If you wait until you’re completely out of debt to invest, you are missing out on years of exponential growth.
2. There Are Tax Benefits To Saving For Retirement
Saving for retirement in an investment vehicles like a 401(k) or 403(b) plan comes with immediate tax benefits. If you save money for retirement through your employer’s 401(k)/403(b) plan, your contributions are pre-tax. Your money is set aside before federal and state taxes are deducted. This means that contributions made in a given year reduce your taxable income for that year.
Let’s say your annual taxable income is $40,000 and your tax bracket is 25%. If you contribute $5,000 to your employer’s retirement plan, you reduce your taxable income to $35,000 and save $1,250 in taxes that year.
In this scenario, if you focus solely on paying off your debts and skip saving for retirement through your employer’s plan, you’re missing out on $1,250 of tax savings.
Let’s not forget employer matching. If your employer matches any of your 401(k) or 403(b) contributions, you should definitely invest at least up to the match or else you are missing out on free money.
3. Not All Debt Is Bad Debt
Most people will need to take on some debt at some point in their lives. For example, the majority of people who buy a home have mortgage debt. This is considered good debt because you are building your equity at the same time. Mortgage loans tend to come with very low interest rates as well – generally under 4% in 2016.
Student loans make up another type of debt that can be good debt. If you plan wisely, your education should result in higher earnings and more life satisfaction. Moreover, the interest rates on federal student loans are fairly low – under 5% for undergraduate degrees and under 6% for graduate degrees in 2016.
The key here is to make sure that the debt has two characteristics:
- It improves your financial situation in the long run.
- It has a low interest rate.
If your debt meets those criteria, you can consider it good debt and mark it as “okay to have.” While you slowly pay down your good debt, you can take advantage of the benefits that come with investing – compound interest and tax savings.
How to Invest Wisely While in Debt
When investing, especially while in debt, it’s a good idea to put your money somewhere that has a historical record of providing decent returns. A good option is a low-cost index fund. Index funds provide broad market exposure while giving you the diversification needed to ensure that the drop in price of any one stock doesn’t ruin your portfolio.
Although past performance does not guarantee future results, index funds that aim to match the standard performance of the market are considered sound investments. Vanguard offers plenty of index funds that track the market and operate with minimal costs.
Whether or not you invest while in debt depends on many factors. There are valid arguments not to invest while in debt, mainly that high-interest debt adds up faster than wealth does. On the other hand, those with low-interest debt will find many benefits to investing such as compound interest and tax benefits. Determining how long it would actually take you to get out of debt, how much of a savings security net you have in place, and whether investments or being debt-free are more important to you personally will all play a role in your decision-making.
Do you think you should invest while in debt?