Payoff Debt vs. Investing
Before anything else, pay off debt first. If you have any high-interest debt, it’s important to concentrate on paying that off first before you start investing. High-interest debt is typically credit card debt or personal loans, I define it as any debt with an interest rate above 7%. I’ll explain later in the post why I use 7% but first let me show you why it’s important to pay off high-interest debt first.
Why it’s important: Debt works the same way as investing except instead of making money while you sleep, you’re losing money while you sleep.
The big picture: The average annual return of the S&P 500 since its inception in 1926 is conservatively about 7%. The S&P 500 is what you might hear when some people speak of the “Stock Market”. It includes the top 500 largest companies in the U.S. that more or less paints a picture of the broader economy.
Making smart moves with how to push your money through can make the difference in what you are gaining or losing. Say you have a credit card with a balance of $5,000 with an interest rate of 20%. You may also have an extra $5,000 laying around after you’ve fully funded your Emergency Fund. A common question I get asked all the time is “Should I pay off my debt first or invest in the stock market?”
If you invest the extra $5,000 in the stock market, on an average year your investment would return $350 ($5,000 x 7%). You just made the equivalent of a roundtrip flight between Hawaii and the West Coast without even lifting a finger. Your money is finally working for you and you’re making money while you sleep. Every year on an average year, you’ll get a free flight to Hawaii or your expectation is you will have an extra $350 to spend on whatever your heart desires. While all that is true and fantastic, it’s not the full picture.
Remember the credit card we decided not to payoff right away? Whilst we deployed our $5,000 to work in the stock market, our debt was out there working as well, just as hard and while you sleep. Assuming your credit card balance remained $5,000, our debt ended up costing us $1,000 for the year ($5,000 x 20%). If you take a look at the big picture, instead of you making money, in reality, you are losing money. A net loss of -$650 ($350 - $1,000).
The exception to the rule of thumb of paying off your debt before investing is if the percentage rate o\f the debt in question is lower i.e. your student loan or mortgage. For example, using the scenario above, with a student loan and an interest rate of 2.75% instead of credit card, your debt will cost you $137.50 for the year ($5,000 x 2.75%). Investing instead of paying down your low interest rate would actually result in you making money. A net gain of $212.50 ($350 - $137.50). This is your opportunity cost. If you decide to payoff low interest debt instead of investing, the opportunity cost is the money you’ll be missing out on.
This is why I don’t recommend paying off debt with a interest rate lower than 7%. Some advanced readers might be thinking they can beat a 7%. Some may do it. For multiple years even, but the probability of beating the stock market over the long term isn’t likely. Back in the early aughts five hedge funds bet Warren Buffet $1 million that they could beat the S&P 500 over the course of a decade. Spoiler Alert: They lost. https://money.cnn.com/2018/02/24/investing/warren-buffett-annual-letter-hedge-fund-bet/index.html
Key takeaway: If the interest rate on any your debt is greater than 7%, pay that off first. Play the odds, put yourself and the people you care about in the best position to succeed, and roll with the winners.