The question of whether or not to invest or pay of debt can always lead to heated discussion with good arguments for both. At the end of the day, it’s really going to come down to how comfortable you are with debt.
Some people don’t care, others are so debt-averse they’ll pay down even the smallest balance at 0% interest as fast as they possibly can. I’m of the general camp that you shouldn’t be lugging around debt just for fun.
If you can pay it off, pay it off. If you can’t pay it off, find a way to start paying it off. Seriously, pay your debt.
Nevertheless, there is a myriad of strategies out there. So if you’re getting defensive about making minimum payments on your student loans while you build a dividend investment portfolio, just chill.
Should you invest or pay off debt?
The following assume you’ve already got your financial bases covered. For example, you’re not behind or have defaulted on any of your debts, and you already have an emergency fund of at least $2,000 (but preferably more).
The question of whether or not to invest or pay off debt should come only after you’ve got the rest of your financial house in order, and you’re looking for the best way to maximize your dollar allocation.
If you’re struggling to meet your bills or have nothing saved in case disaster strikes, you have more pressing things to worry about than where you’ll get the best return on your money. However, if you’ve got everything together, read on.
Is the interest rate on your debt higher than the return you expect to earn on your money?
As a general rule of thumb, you should be earning 2 to 3 times more in the market than your paying on your debt. This means if your debt is at an interest rate of 3%, you should be getting a return of at least 6%.
Why 6%? Because if the difference between your debt and rate of return in the market is only 1-2%, the weight and risk of carrying debt far outweigh the benefits of your rate of return in the market.
Some of the risks of choosing to invest instead of paying off debt are:
- Companies can cut their dividends. You can go from getting a 5%+ yield on a stock to 2% in a single announcement. Additionally, a dividend cut typically negatively impacts the stock price, reducing the capital you can retrieve from the investment.
- The market does not provide a guaranteed return. Historically, stock market averages are fairly juicy, but the average is just that: an average, which means it’s mixed with some up and down years.
- Your creditor can increase the interest rate on your debt. If you owe an organization money, they’re in charge, not you. This means they can up your interest rate at any time, and all they need to do is send you a letter to let you know they’ve done so. Many students are lured into large debts with super low interest rates, like 0% to 3%, when they’re in school, only to see that number jump to 5% or more after graduation.
For this reason, it’s often better to opt for aggressively killing your debt before you focus on investing.
Is your debt balance above $20,000?
This is an arbitrary number, but it’s a good benchmark. The higher your debt owing, the more interest it accumulates — even at a low interest rate.
If you owe $25,000, your interest rate is 3%, and your monthly payment is $150, over 40% of your monthly payment is going towards interest and not touching your principle. At the end of the first year you would have made $1,800 in payments towards your debt, but only reduced the balance by just over $1,000.
That’s $800 that’s disappeared to interest and is more or less the cost of carrying the loan. Is it worth lugging the debt around around for $800?
The bigger your balance or the higher your interest rate, the faster it works against your monthly payment. Even if you’re eager to get started in the stock market, make an effort to knock your debt balance down to something that won’t choke your efforts. Annihilate a good portion of your debt, then begin splitting your efforts between paying down the balance and saving on the side.
Do you want to make a significant purchase, such as a home, in the near future?
Many people often forget that debt can be a drag on their future plans. We are so comfortable with balances owing, that we shrug and lug around student loans, lines of credit, and so on for years… until they get in the way of something we want.
When it comes time to buy a home, how much house you can afford is not just about the down-payment, your affordability will be assessed by the monthly mortgage payments you can make. If you have recurring loan payments, this is money that can not go towards house payments, and therefore is deducted from your affordability.
So it’s up to you: do you want to spend $300 per month on credit cards or a car, or do you want it to go towards building equity in your dream home?
Did you purchase stupid things with your money?
This point is purely about the emotional cost of debt. Fundamentally it doesn’t actually matter if the $100 you owe on your student loans bought you a textbook for calculus class or five extra-large pizzas, it’s still $100 owing.
But there’s something less frustrating about paying interest on the money you borrowed to feed your mind, than money borrowed to feed your fun.
If you want to pay 3% or 5% or whatever interest for 5 years on the beer you drank in college, that’s fine — but personally I balk at places that charge $8 for a pint, so I can’t imagine the final cost coming to $10 or $15 after interest however many years down the road.
Go back through your old credit card statements or tuition bills, and figure out where your money went. Pay off the bad purchases as fast as you can, even just for pure peace of mind. Even if your interest rate is low, you’re getting a good return in the market, your debt is tiny, and you have no need for a mortgage in the future, I’m going to shake my head at you if you’re carrying the cost of Starbucks lattes around.
You can always adjust your debt repayment and investment strategy as you go.
I took a blended approach when I paid down my debt, opting to save and invest on the side. At first, this made me feel financially secure like I was covering all my bases.
But as the months passed, I became frustrated with my debt and eventually cashed out a lot of my savings vehicles to wipe out the remaining balance.
In other words, what you do right now isn’t what you have to do forever.
If you try a debt and/or investment strategy that doesn’t work for you or doesn’t feel right, you can change it later, the most important thing is that you continuously work towards maximizing your net worth.