Pay down debt or invest?

I recently saw financial advice online that said that you should invest money before paying your low interest debt. Low interest was defined as anything less than 7% interest. The reason given was that the market has historically returned more than 7%, so you are better off investing than paying off your debt. This advice is not uncommon.

Over the past 65 years, the S&P 500* has seen average annual returns of 10.7%. This is excellent! But, if we look at investing in the short term, we see a different picture. In 2015, the S&P annual return was 1.4%. In 2016, 12%. In 2017, 21.8%, and in 2018, -4.4%.

If you don’t have a financial strategy and end up needing money you invested, you might be put in a position of withdrawing funds during one of those particularly bad times, like when 2018 saw a -4.4% return. Worse yet, you might be withdrawing funds at a time that has penalties or tax implications (early withdrawals in retirement funds). Over time, buying and holding investments is a great strategy and sound financial advice AND part of a very important financial plan, but what happens when you make that choice while maintaining debt?

For a simple example, let’s say that you have a credit card with a balance of $10,000 and, hypothetically, that credit card has a 7% interest rate (super unlikely – credit card interest rates are much higher typically).

At the end of any given month, you have $1,000 leftover in your bank account that you have not planned to use for anything else and you have already paid the minimum due on the credit card at hand. The above financial advice would say to put $1,000 into an investment account each month.

If, instead, you put that $1,000 towards the $10,000 balance on your credit card each month, you accomplish a few things.

1.     Your balance declines. The first month, it becomes $9,000 (plus interest), the next $8,000 (plus interest, but declining interest), and so on.

2.     After about 10 months, the credit card balance is gone.

3.     You guarantee a return that you cannot guarantee when it’s invested.

4.     Your minimum payment is gone, leaving more money in your overall budget.

Let’s take each one of these points in turn. First, the interest on a $10,000 balance at a 7% rate is approximately $58.30 a month. If you invest the $1,000 and don’t pay it towards your credit card, the interest attaches to the $10,000 and the balance becomes $10,058.30, and that entire new and larger balance accrues interest the next month.

Second, if you invested the $1,000, and did this each month for 10 months, and got a 7% return annual return, at the end of 10 months, you would have $10,326.51 invested. If you invested instead of paying off the credit card debt, you would have $10,598.89 in credit card debt at the end of ten months. Without paying off the credit card, it just continues to grow, and at a faster rate because of the initial higher balance which upon which interest compounds. If you only make the minimum payment, you likely never make a dent in the principal.

Third, while we don’t know exactly what the stock market will do, we know exactly what our interest rate is on our debt. By paying off our debt, we guarantee that we will not be paying that amount of interest each month.

The final point is the most important to me and underlies the Bottom Line philosophy. When we have debt in our budget, we must have more income to maintain that debt. When we remove debt, we require less income to live on. Requiring less income gives us more flexibility and freedom of choice. Let’s say your budget looks like this:

Rent:                                    $800

Utilities:                       $200

Credit Card Payment:     $200

Groceries:                     $500

Dining Out:                       $200

Car insurance:              $150

House items:                    $100

Car Payment:                    $500

Student Loan Payment: $300

TOTAL:                       $2,950

In this example, you need $2,950 a month to live (this is not what a Bottom Line Budget looks like, but as an example). If you earn $4,000 a month, you have $1,050 a month leftover. If you didn’t have the debt in this example (car payment, student loan payment, and credit card payment), you would only need $1950 a month to live, leaving $2,050 a month leftover. This is freedom.

Debt is rented money. Would you rent money to invest it? Likely not. Would you rent money to buy a cup of coffee? Likely not. But when we carry debt around and make other choices, we are in fact doing just that – we are paying for the opportunity to use that money.

I want to be very clear. Investing is great. Let’s say that in 10 months you saved and invested $10,000 and you were able to invest it for the long run (40 years) in a fund that tracked the S&P and had an average return of 10.7%. At the end of 40 years, that $10,000 would grow to over $583,000. That’s amazing!

A financial plan needs to ensure that you don’t rely on debt, that you are able to leave the money invested for the long haul, and that you have your needs covered for every day. Without that, investing while in debt is risky.

* The S&P 500 is a stock market index which includes 500 of the largest US companies. The S&P 500 is used as a common benchmark for how the overall market is performing.