investing

It’s a tough choice to make.


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Do I put money aside to harness the magical power of compounding…OR do I set aside my hard earned dough to pay off that intimidating debt I have?

Debt is everywhere – whether it’s a house loan, consumer credit loan, or money you owe because of a bad day at the racetrack. For those of us who have enough money coming in to keep ourselves fed, watered and happy…it seems like paying off our debts first and fast is the only way to go. But is it?

While it’s definitely a good feeling to be debt-free, sometimes it makes sense to just maintain your debt, i.e. pay the minimum required, while investing your extra cash.

So…what do I do? It’s not an easy choice. There are a handful of factors.

 

1. Compounding

One thing many people do is compare the rate of interest they would earn (expected return) on an investment versus the rate of interest they would have to pay on their debt.

That…can be a mistake. On one level this makes sense, if the difference between the two is positive (i.e. you would earn more from investments than you would have to pay), then you would move your money into an investment.

The problem with this decision is the opportunity cost. Opportunity cost refers to the potential loss, how much you would lose, from an option that isn’t chosen. It’s the cost of a missed opportunity, and the opportunity here is related to how early you start investing.

While you can always get the return from the first year you invest, you will never get the return from a year that you did not start investing. It sounds simple and it is: you can’t earn if you’re not invested. And because of time, the magic factor when it comes to compounding, how early you start is super important. The more time you give yourself, the better. Don’t just compare that first year’s return but the years you would miss if you didn’t invest NOW.

Throw in the fact that any year’s return will likely be higher than any interest you pay on debt in the first year and you have a solid reason to invest rather than pay off debt.  Think of yourself as a bank and the difference between your investments and your liabilities as your “spread”, and that’ll help get you in the right mindset.

2. You could be leaving free money on the table

If your employer offers a generous retirement matching program and you aren’t taking advantage of it then shame on you. This is essentially free money and it makes sense to take full advantage before allocating money elsewhere.

Additionally, most retirement plans have very specific start dates. Especially the ones that are linked to your employer such as the 401(k), 403(b) and IRA plans. This ties back into point 1 about the magic of compounding because once you get past a certain date (cough, cough, April 15) then it’s too late. You don’t get to benefit from the magic for that year.

There are also limits to the AMOUNT you can contribute every year. So if you wait and suddenly have all this cash you want to invest, you actually may not be able to because you have more than your allotted amount. So if the limit is $5,000 a year and after 2 years of zero investment I suddenly wake up and want to invest $30,000 I wouldn’t be able to. Womp womp womp.

Don’t let that be you.

3. You have low interest rates on your credit card

This is related to point 1, wherein if you have credit card debt and a low interest rate on your credit card, it makes sense to allocate money towards investments and pay off your debt over a longer period of time. Some credit cards even offer generous 0% interest rates as an introductory offer – which means you can hold off on repayment and put that extra cash to work.
Be careful though. These introductory rates don’t last long (generally a year) and afterwards the rates can skyrocket to 20% or more, so make sure you read the fine print carefully.

4. Emergencies

Paying off debt can give you peace of mind, but it should never come at the expense of having an emergency fund. Ever. Sure, you may not have debt holders breathing down your neck but they aren’t going to be there to help if you lose your job or, god forbid, have an unforeseen medical emergency. An ambulance ride alone can bankrupt people in precarious financial situations, let alone an actual stay at the hospital.

This isn’t investing in the usual sense, but it is a way of investing in yourself and your future.

5. You have good debt

All debt is not created equal. Debts can be separated into good debt or bad debt depending on the underlying asset.

If the underlying asset is something that increases in value over time, then it’s “good” debt. For example, a rare coin collection or your college education. A lot of people consider a home to be “good debt”.

If the underlying asset is something that decreases in value over time, then it’s definitely bad debt. So something like a car or furniture would be an example of bad debt. You typically can’t sell a car for more than what you paid for it. That’s bad debt.

Remember how we asked you to think of yourself as a bank?

That means you should apply the same sort of rigor to your finances as a bank would. Create your own financial statements that list your debts: good and bad. Write down how much you owe, the minimum payment and how long it would take to pay it off. Separate your debt into good and bad debt. If you only have good debt…then you can maintain that debt while investing spare cash. If you have bad debt, then pay it off first. Simple!

So these are a few reasons to consider investing over paying off debt. While certainly not exhaustive this is a good framework from which to start.

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