Invest or Pay Off Debt, It's a No Brainer
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patrick
Ever wonder why so many financial advisors push you to start saving right now, even if you are burdened with insurmountable debt? The answer is simple: Financial advisors are commissioned salespeople. If you don't buy what they sell (the investments) they don't get their commission (trailer fees).
Many advisors will emphasize that the power of compounding outweighs paying a few bucks in interest every month. Which is true; but a few bucks in interest is unlikely for most of us (the average American carries $22,100 in debt). As a result, investing early and making credit payments will hinder your lifestyle and keep you in debt.
We can put this argument to the test by knowing your Cash Dilution Rate. What this rate reveals is exactly how much we give away to the people we owe money to. For example, if we earn $100 after-tax and have a dilution rate of 16%, we enjoy only $84 of this money. The higher our rate, the more it makes sense to forego investing right now in favor of repaying our debt.
Taking a closer look, we can consider someone who earns $2,000 in after-tax income. Match this to the average American debt of $22,100 that carries an average rate of 13.35%, and this individuals sees only $1,732.86 of her $2,000.
For a better appreciation of this situation and how severe it can be, let's pretend her advisor encourages her to invest a "modest" $250 per month. Combined with the $267.14 she pays in credit debt, she is left with less than $1,500 to enjoy the rest of her life. Even though she started with $2,000 she loses an additional 25% and has much less to pay for other expenses like rent, mortgage, entertainment, etc.
If this individual actually had no debt, then the $250 in investments would work perfectly because she is already paying more than that every month on her credit repayment. What impact will repaying debt and investing at the same time have on her long-term savings? That will depend on two things.
In the first case, this investor might find that an additional $250 per month to invest is, in fact, not much of a sacrifice. If this is the case, then that additional $250 should still go toward repaying debt (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). This would reduce the debt even faster, from a little more than 57 months until full repayment without using the extra $250, to a little less than 35 months if she uses that $250 to repay the debt. Once all of the debt is repaid, the $250 + $267.14 can be invested for a total investment value of $517.14 per month.
Another factor weigh is timing. If our investor has only 15 years left, as of today, that means she loses 3 years of potential compounding. The impact will this have on her savings is minimal. By deferring her $250/month savings and repaying debt instead and then, in three years investing $517.14 per month instead, this individual will have saved $38,283 more over 12 years (remember, she lost 3 years by repaying that debt first) assuming the rate of return is constant and she can still invest $250 plus the $267.14 she saves in credit repayments. More importantly, after 3 years, she will be debt-free, which automatically puts her in a better position to tackle unplanned financial hardships.
Now let's assume that after sacrificing so much for three years while repaying her debt, she doesn't want to invest the full $250. Instead, she will take $125 and buy something she enjoys, like shoes, and invests only the remaining $125. Even though she has given up half of her originally planned savings, she is still investing $392.14 ($125 plus the $267.14 she formerly paid to debt). The impact? Also negligible, even though she "lost" three years of compounded growth. In dollar terms, she will be farther ahead by $7,167 if she repays all debt and invests only $392.14, compared to starting today with $250 per month and still having the debt in three years.
As you might have guessed, debt repayment should almost always take priority over an investment program. This seems counterintuitive to a lot of what our advisors tell us, but in most cases we can repay debt faster and thereby invest more, if our after-tax dollars are used more wisely. In some cases, you should consider an investment strategy in conjunction with a repayment plan, but those situations are rare.
Many advisors will emphasize that the power of compounding outweighs paying a few bucks in interest every month. Which is true; but a few bucks in interest is unlikely for most of us (the average American carries $22,100 in debt). As a result, investing early and making credit payments will hinder your lifestyle and keep you in debt.
We can put this argument to the test by knowing your Cash Dilution Rate. What this rate reveals is exactly how much we give away to the people we owe money to. For example, if we earn $100 after-tax and have a dilution rate of 16%, we enjoy only $84 of this money. The higher our rate, the more it makes sense to forego investing right now in favor of repaying our debt.
Taking a closer look, we can consider someone who earns $2,000 in after-tax income. Match this to the average American debt of $22,100 that carries an average rate of 13.35%, and this individuals sees only $1,732.86 of her $2,000.
For a better appreciation of this situation and how severe it can be, let's pretend her advisor encourages her to invest a "modest" $250 per month. Combined with the $267.14 she pays in credit debt, she is left with less than $1,500 to enjoy the rest of her life. Even though she started with $2,000 she loses an additional 25% and has much less to pay for other expenses like rent, mortgage, entertainment, etc.
If this individual actually had no debt, then the $250 in investments would work perfectly because she is already paying more than that every month on her credit repayment. What impact will repaying debt and investing at the same time have on her long-term savings? That will depend on two things.
In the first case, this investor might find that an additional $250 per month to invest is, in fact, not much of a sacrifice. If this is the case, then that additional $250 should still go toward repaying debt (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). This would reduce the debt even faster, from a little more than 57 months until full repayment without using the extra $250, to a little less than 35 months if she uses that $250 to repay the debt. Once all of the debt is repaid, the $250 + $267.14 can be invested for a total investment value of $517.14 per month.
Another factor weigh is timing. If our investor has only 15 years left, as of today, that means she loses 3 years of potential compounding. The impact will this have on her savings is minimal. By deferring her $250/month savings and repaying debt instead and then, in three years investing $517.14 per month instead, this individual will have saved $38,283 more over 12 years (remember, she lost 3 years by repaying that debt first) assuming the rate of return is constant and she can still invest $250 plus the $267.14 she saves in credit repayments. More importantly, after 3 years, she will be debt-free, which automatically puts her in a better position to tackle unplanned financial hardships.
Now let's assume that after sacrificing so much for three years while repaying her debt, she doesn't want to invest the full $250. Instead, she will take $125 and buy something she enjoys, like shoes, and invests only the remaining $125. Even though she has given up half of her originally planned savings, she is still investing $392.14 ($125 plus the $267.14 she formerly paid to debt). The impact? Also negligible, even though she "lost" three years of compounded growth. In dollar terms, she will be farther ahead by $7,167 if she repays all debt and invests only $392.14, compared to starting today with $250 per month and still having the debt in three years.
As you might have guessed, debt repayment should almost always take priority over an investment program. This seems counterintuitive to a lot of what our advisors tell us, but in most cases we can repay debt faster and thereby invest more, if our after-tax dollars are used more wisely. In some cases, you should consider an investment strategy in conjunction with a repayment plan, but those situations are rare.
About the Author:
Chris Blanchet has over fifteen years of experience as a Financial Advisor. He is the author of the Personal Finances e-Book Help Fix My Finances, which is the basis of the Members Only website the same name. Be sure to visit his Debt Free Blog.
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