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The No Brainer: Pay Off Debt or Invest?
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by: ChrisBlanchet
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Word Count: 767
It should not come as a surprise why financial advisors will tell you to start investing now, even though they all agree behind closed doors that eliminating debt should be a financial priority. The reason they do this? They have families to feed, too; if they don't sell their product (investments) they don't eat.
Many advisors will emphasize that the power of compounding outweighs paying a few bucks in interest every month. Which is true; but a few bucks in interest is unlikely for most of us (the average American carries $22,100 in debt). As a result, investing early and making credit payments will hinder your lifestyle and keep you in debt.
We can put this argument to the test by knowing your Cash Dilution Rate. What this rate reveals is exactly how much we give away to the people we owe money to. For example, if we earn $100 after-tax and have a dilution rate of 16%, we enjoy only $84 of this money. The higher our rate, the more it makes sense to forego investing right now in favor of repaying our debt.
Let's look at this a little closer. Consider an individual who earns $2,000 in after-tax dollars. With the average American debt of $22,100 and an average rate of 14.5%, this individual's Cash Dilution Rate rings in at 13.35%. This person keeps only $1,732.86 of her original, after-tax $2,000.
For a better appreciation of this situation and how severe it can be, let's pretend her advisor encourages her to invest a "modest" $250 per month. Combined with the $267.14 she pays in credit debt, she is left with less than $1,500 to enjoy the rest of her life. Even though she started with $2,000 she loses an additional 25% and has much less to pay for other expenses like rent, mortgage, entertainment, etc.
If this individual actually had no debt, then the $250 in investments would work perfectly because she is already paying more than that every month on her credit repayment. What impact will repaying debt and investing at the same time have on her long-term savings? That will depend on two things.
The first thing to consider is whether this individual can indeed afford to invest $250 per month. Assuming she can, then she should really refocus this money toward debt repayment (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). By using this extra $250 to repay debt, she will reduce her repayment schedule from 57 months to a little less than 25 months. That means that in 3 years, she invest both the $250 that the advisor recommends and the $267.14 that she is already paying toward debt, for a total of $517.14 per month.
Another factor weigh is timing. If our investor has only 15 years left, as of today, that means she loses 3 years of potential compounding. The impact will this have on her savings is minimal. By deferring her $250/month savings and repaying debt instead and then, in three years investing $517.14 per month instead, this individual will have saved $38,283 more over 12 years (remember, she lost 3 years by repaying that debt first) assuming the rate of return is constant and she can still invest $250 plus the $267.14 she saves in credit repayments. More importantly, after 3 years, she will be debt-free, which automatically puts her in a better position to tackle unplanned financial hardships.
Now let's assume that after sacrificing so much for three years while repaying her debt, she doesn't want to invest the full $250. Instead, she will take $125 and buy something she enjoys, like shoes, and invests only the remaining $125. Even though she has given up half of her originally planned savings, she is still investing $392.14 ($125 plus the $267.14 she formerly paid to debt). The impact? Also negligible, even though she "lost" three years of compounded growth. In dollar terms, she will be farther ahead by $7,167 if she repays all debt and invests only $392.14, compared to starting today with $250 per month and still having the debt in three years.
As evidenced above, accelerating a debt repayment plan should often take priority over investing for the simple sake of future compounded growth. This statement contradicts a lot of what has been written already about wealth building, but the illustration above shows us just one way a debt-free lifestyle allows us to enjoy greater wealth down the road. Of course, there are some rare instances where an investment plan should be used in conjunction with a debt repayment schedule but, again, those situations are rare.
About the Author
Chris Blanchet has over fifteen years of experience as a Financial Advisor. He is the author of the Personal Finances e-Book Help Fix My Finances, which is the basis of the Members Only website the same name. Be sure to visit his Debt Free Blog.
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