A quick look into the pitfalls of investing while still paying off debt.
If you are the type that is ready to rock and roll, then you are probably ready to start investing your income as the big players do. Stocks, portfolios, investments, Wall Street, the 1%; these are all terms that we hear every day from so many social posts and media outlets. They are constantly in the back of our minds telling us this is where it is at. We must start investing in the market as soon as possible, or we will never be wealthy. Unfortunately, there is so much more to the story, and today we are going to discuss why investing while you are in debt is counterintuitive.
What do we mean by investing?
Any money that you use to purchase an asset with the intention of that asset increasing in value is considered an investment. There are so many types of investments out there, including mutual funds or single stock securities, bonds, options, partnership interests, and start-ups. The list goes on. You are giving money to a person, group, or cause with the expectation you will receive again on that money in the near future. This could come in the form of interest, dividends, or an increase in the market value of the asset when sold (capital gains).
What do we mean by debt?
Debt is the amount of money that you owe to another person, or company, because of an obligation or surety contract that you signed. This obligation contract allows you to receive something now that you do not have the cash to purchase outright. The terms of the obligation allow you to repay the creditor (person who loaned you the cash to purchase the asset) over a certain period. Finally, the obligation also includes a cost associated with borrowing the money or interest. There are 2 detriments to your future wrapped up in loans and obligations; the 1st is the interest, and the 2nd is the burden you now bear of paying back money that you might not ever have.
Why you do not invest when you owe interest.
BE VERY CLEAR ABOUT THE FOLLOWING STATEMENT: there is not an investment vehicle in the world that will consistently out invest our debt. I know you just thought of 5 internet personalities that have a YouTube video proving me wrong. Around this firm, we do the math, and the math wins every time. For simplicity, let us assume that you are investing $5,000 a year into an account with a current value of $100,000. Your chosen set of mutual funds is slightly outperforming the S&P (which it should) by a few points, say 10%. You are in an income tax bracket of 15%, and you have about $80,000 in student loan debt at 6.25%, and $20,000 in credit card debt at 18%. At this rate, you are making about $10,000 a year on the account. That is awesome. If you withdraw the income (even later during retirement) at a 15% tax rate, then you will have $7,750 left (this considers the tax you owe on the $5,000 of income you have already made). Do not forget about inflation because that is going to reduce your purchasing power by about another 3% leaving you with about $7,520. Let us see what you are paying out in debt payments; approximately $5,200 in student loan interest is paid out annually, and approximately $3,600 is being paid out in credit card debts for a total of $8,800. After we do the math, we see that Uncle Sam and interest have taken all our income, and it also requires we pull a bit of money out of the investment account to make the full debt payment. I realize that math was simple, and that tax projection was even more so, however, you see where this ends up. You are not making money in this situation; you are losing money. You will also continue to lose money for the next 30 years leaving you with a balance of approximately $60,000 in your investment account. Can you retire on that?
What if I pay my debt off first, then invest?
That is a great question, reader. Let us take a quick look. We are going to apply the full $100,000 from the investment account towards debt in year one. That means we did not have to make any interest payments towards the loan; however, we do not have $10,000 in income either. So, our final step is to invest the $5,000 of other income that we had originally into the investment account that is now at $0. How will this play out in 30 years if we start back at $0? Would you believe that you will have approximately $820,000 in your investment account at the end of 30 years? Go ahead, Google the “time value of money” formula and try out the math.
Someone once told me that every situation is different. That is simply not true when it comes to debt. You cannot out invest debt, even with real estate. Also, the borrower will always be a slave to the lender, and that is not the type of relationship that we want to build. Be smart, be money savvy, think about the math, and not the emotion. Follow us right here for more tips to becoming money savvy.