Should you invest or pay off debt? It’s a question I hear regularly.
Everyone’s financial situation is a little different, so there really isn’t a one size fits all answer to this question. I’ll take you through my thoughts on paying off debt vs investing as a general guide and some ideas on how you might approach it!
Meet Ben and Claire
Ben and Claire are married and both in their early 30s. After reading a bunch of great books about investing in the past few months, they are excited to get started ASAP. They too are asking the question – should we invest or pay off debt first?
Here’s a snapshot of their current household debt situation –
- Mortgage repayments – $2,300 a month (6% interest)
- Car loan repayments – $900 per month (7% interest)
- Credit Card #1 – $7,000 owing (19% interest)
- Credit Card #2 – $800 owing (14% interest)
Ben and Claire can meet all their required or minimum debt repayments comfortably but often only pay the minimum off the credit cards.
They have around $800 – $1000 per month of ‘surplus’ income they can either invest or put towards paying off debt. The good news is they identified their surplus and know that they need to use this money to improve their financial future.
Factor #1 – The type of debt and amount of interest you’re paying
The types of debt with the highest interest rates are usually shiny pieces of plastic – the credit cards.
Credit card interest rates can range anywhere from 10% – 20%.
These types of rates are serious wealth killers and you want to focus on getting rid of them as quickly as you can.
I’d recommend Ben and Claire focus on paying off their two credit cards as quickly as possible before investing. The contrarian view on which one to pay off first is that I would actually start with the small $800 debt and get rid of it. See below for my explanation as to why.
Investing returns are historically less than the interest Ben and Claire are paying on these cards.
If they were to invest while still getting hit with high credit interest, any returns earned on their investments would be canceled out by the amount of interest they’re paying on the cards.
In a nutshell – their debt is costing them more than they’d earn in returns from their investments.
If you have debt with an interest rate of more than 12%, my advice would be to focus on paying it off ASAP before investing.
Ben and Claire’s credit card repayment strategy –
In Ben and Claire’s case, I’d recommend clearing the smaller amount first – Credit Card #2 (while still making minimum or above minimum payments on Credit Card #1) then move onto paying off Credit Card #1.
This debt repayment approach has been coined The Snowball Method. It’s become a popular strategy for tackling multiple debts, working from the smallest to the largest – rather than focusing on the interest rate. There is science behind the reason for this strategy, which we don’t need to get into, just understand that the mindset benefits of eliminating debts have a positive impact on your ability to continue with the larger debts.
Once those cards with killer interest rates are knocked out, Ben and Claire could choose to split the $800 – $1000 they were paying towards the cards each between investing and making extra payments on the car loan to pay it off faster.
Or, they might stick with the usual monthly car payment and put the $800 – $1000 towards investing.
There’s no one right answer for each individual situation but a reasonable, conservative guide to use is –
If a debt has an interest rate of more than 8%, focus on paying it off. Less than 8%, you could stick with the usual repayments and put your extra cash towards investing instead.
This rule is flexible and based on what is happening with financial markets at the time, but for now, it is a good guide.
Factor #2 – It’s not all about mathematics
Money is emotional stuff. Our financial lives are driven by habits and our attitudes about money. Just because we’ve got all the numbers worked out on paper – doesn’t mean we follow through on what we need to do. Which is why I don’t believe in budgets.
Getting into the habit of investing, even while you’re working to pay off debt, can be a good thing.
The focus is on building a regular investment habit, rather than getting caught up in the amount of money invested. So, Ben and Claire could choose to put just $100 aside each month for investing while they focus on paying off their high-interest debts. They can open a simple micro-investing account to do this.
Sure, $100 a month isn’t going to transform their financial world any time soon but the amount isn’t the point, forming the habit is.
If Ben and Claire take 9 months to pay off their high-interest credit cards, along the way they’ve gotten into the habit of investing too.
Once their high-interest cards are cleared, they can begin to channel a big chunk of the money they were paying towards the cards, to investing. They can move from their micro-investing account and open a brokerage account, invest in ETFs or start working toward an investment property, or both.
The good news is, whether you’re focused on paying off your debts as quickly as possible or investing your money both are steps towards securing your financial future.
The sooner you can get on top of your consumer debt, the sooner you can start accumulating investment-grade assets that will put money in your pocket rather than take it out like credit card debt does.
If you are ready to change your financial future and want to talk about how you can get started, schedule your FREE Smart Investor Consult Call here. There is nothing to buy and nothing to lose. If not now, then when, right?