Cut Debt or Invest? Why Not Both?

by Brian Dolan

Get Out of Debt or Invest?

The idea of paying down your debt and investing at the same time might seem like a tall order for many people. Indeed, most personal finance advice routinely implores people to pay off their debts before they begin saving and investing. The idea seems straightforward enough: get out of debt, and then you can begin to save.

Recent graduates and others just starting out may even seek to accelerate their debt payments, aiming to become debt-free as soon as possible. However, depending on your individual circumstances, eliminating debt before saving and investing may not always be the best long-term approach. It comes down to simple math and the opportunities of long-term investing.

First, the math part. In the simplest terms, if the interest rate on your debt is below historical long-term investment returns (see below), it may make more sense to devote any extra money

to saving and investing rather than paying down debts more quickly. If the interest rate on your student loans is 4%, for example, and the historic rate of return on US large-company stocks is over 9%, you could potentially earn an extra 5% per year by devoting any extra funds to investments. (Of course, past performance is no guarantee of future results.) If you’re determined to pay down debt faster than required, it’s still worth considering allotting at least a portion of any surplus funds to investments.

The concept doesn’t work if you’re sitting on a pile of credit card or other high-interest rate debt, with rates above 10% or higher for instance. In that case, you’re better off eliminating that high-interest rate debt as soon as possible, as the interest you’re paying likely exceeds what you could reasonably expect to earn by investing.

The idea of re-paying your debt and investing at the same time becomes even more attractive if you have access to a tax-advantaged savings plan, such as an employer-sponsored 401k or an individual IRA. If your employer’s 401k comes with a company matching contribution, the rationale is even more compelling. Try to save the maximum allowable and at least enough to get the full company matching contribution. It’s like free money and being paid to save.

An even more powerful reason for saving and investing while you pay off debt is the secret of long-term investing—the power of compounding. With compounding, the simple rule is the sooner you start saving, the longer your investments have time to grow. Albert Einstein referred to compounding as the ‘eighth wonder of the world.’ See the results of an investor who started saving $100 per month at age 25 (30 years of compounding) compared with one who waited 10 years to begin investing at age 35 (20 years of compounding–8% annual return).

Postponing 10 years could cost you $84,495

The Power of Compounding Versus Your Debt

The power of compounding can hardly be underestimated. The key to unlocking it is to start building your nest egg as soon as possible, no matter how little you might be able to afford. With compounding, every little bit adds up.

What if you’re saddled with so much debt you can barely make the required payments, much less find any money to save? If you have multiple debts, such as several student loans, you might consider combing them with a consolidation loan. The interest rates on consolidation loans are determined by the weighted average interest rate of all loans, rounded up to the nearest ¼%. As such, consolidation loans will typically increase the average interest rate on the combined loans. But by extending the term of the loan, from 10 years to 15 years, for instance monthly payments can be lower, potentially freeing up savings.

Dedicating yourself to a saving and investment routine will also reinforce other positive financial behaviors, such as living within a budget, avoiding unnecessary debt, and generally being more financially aware. You’ll also gain the satisfaction of knowing that you’re building your net worth and accumulating assets for your future. Positive financial habits have been shown to be the single biggest predictor of financial success in life.

The common wisdom may be to pay off debt as soon as possible before focusing on saving and investing. Everyone’s situation is different and so the approach to managing debt and investing will vary from individual to individual. If the math of your situation supports it, you should aim to begin saving and investing as soon as possible to unleash the power of compounding and start building your financial future. Someday those debts will be paid off. Wouldn’t you like to have some positive assets growing for you in the meantime?

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Cut Debt or Invest

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