It’s easy to pound our fists and say, yes, debt is, quite obviously, strangling us one dollar at a time. But is debt, in essence, actually bad? Furthermore, should all debt be treated equally? For too long we’ve roped a wide range of debt into one, malicious-looking lump, whether that be debt from credit cards, mortgages, student loans, personal loans or car loans. Instead, we need to be diving into these types of debt and discovering which types can be managed, which should be embraced and which should be avoided like the plague.
Investments vs. Debt
There are two main advantages to debt. That’s right; there are some (emphasis on some) potential benefits to being in the hole. The first is the most obvious: You don’t have to pay the total cost upfront. This works for major purchases, such as a home or college tuition, which would be unreasonably expensive if you had to pay the entirety upfront.
This advantage gives way to the next, more profitable benefit to (some) debt. Too often do I see people who, with good intentions, try to pay down their debt as quickly as possible. They think, hey, since debt is bad and I can afford to pay more than the minimum payment, I should use that money to crack away at my debt at a faster pace. They become so focused on the debt that they don’t take the time to consider investing their excess money.
According to historical trends, inflation and the advice from Warren Buffet, investing in the stock market will typically give you an annual return of 7%. You’ll have some years where you’ll receive much higher returns, as well years where you’ll get lower ones (think 2008), but when you average the highs and the lows, it’s good to plan for 7%. This means, in some cases, it actually makes more sense to invest excess money rather than using it to pay off your debt faster.
But not always.
Each person has a unique situation, so before you decide to invest every penny in Coke or Apple stocks, take a few steps back and do the math. First of all, you need to discover what your debt will cost you over the life of your loan (Note: If you have multiple forms of debt, you may want to see if debt consolidation is right for you.). I recommend that each person start with a loan payment calculator. By doing this, you are able to see how extra payments on your loan will affect your overall amount of debt.
For example, let’s say that Kollin has $30,000 in federal student loans, which we’ll say has an interest rate of 4.63%. If he continues to pay the minimum payments, Kollin will end up paying $7,535.79 in interest payments alone.
But if Kollin decides he is going to pay an additional $500 each month to tackle his debt faster, according to our calculator, he’ll knock his interest payments down to $2,428.47. This means he’ll have saved over $5,000 in interest payments over the life of his loan. These are some impressive savings.
However, if Kollin pays the minimum amount on his loans and invests that $500 each month for ten years, an investment calculator (at 7%) will show that he’ll be walking away with over $88,000. If you take away the minimum payment total ($7,535.79), that’s still a savings of over $80,000 in ten years.
In other words, in this particular case, it makes more sense for Kollin to invest rather than pay off his debt faster. If he continued saving at that rate for another ten years, he would have a total of $263,191.08.The power of the stock market is in the time, so even if Kollin cracked out his debt first and then started investing, he would still be making less money than if he was investing all along.
Exceptions to the Rule
Unfortunately, not everyone is in the same boat as Kollin. For instance, if the interest rate of the debt is higher than the interest on the investment, you wouldn’t be coming out ahead by investing your excess money. Personal loans and debt from credit cards are pretty classic examples of this. As of last year, credit card interest rates were up to 15.07%. This is quite a bit different than a 4.6% interest rate.
In other words, you shouldn’t be thinking about investing if you’re overwhelmed by credit card debt. Getting credit card debt under control should be a high priority for anyone who’s serious about increasing their wealth. If you want to use credit cards as a way to rack up the points, that’s fine, but pay off the debt at the end of the month, every month. This isn’t easy, so make sure you’re setting a strict budget for yourself to help you prepare an emergency fund and manage your spending.
When It’s Best to Invest
Much like Kollin’s example, there are specific situations when investing is a much better alternative to paying off your debt faster. Student loans and mortgages are classic examples of (typically) low-interest debt. As long as your debt is hovering around 6% or lower, it’s usually better to continue making minimum payments on your loan, while investing any excess funds.
When in doubt, use your calculators to decide which option is best for you. Investing your excess funds is not an excuse to let your spending be out of control. That said, debt doesn’t always have to be a monkey on your back. In many cases, it can be a tool used to get you ahead in the game. There will always be risk in investing, but statistically, putting money toward investments can be the best decision for you and your bank account. As always, it’s a good idea to speak with a financial advisor to make sure you’re doing what’s right for your situation.
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