| The No Brainer: Pay Off Debt or Invest? |
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| Written by Chris Blanchet |
| Monday, 08 June 2009 13:06 |
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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.
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. Okay, the power of compounding is certainly a valid argument that advisors will make. However, this argument is invalidated if you carry $22,100 in debt like the average American and your income hovers around the median. In other words, a few bucks in credit payments is different than struggling with payments and investing at the same time. We can see whether the argument is valid once we know our Cash Dilution Rate. This rate essentially tells us how much of our after-tax dollars we lose to the credit debt we have. So, the higher the rate, the more we pay to creditors; the lower the rate, the more of our after-tax dollars we enjoy and, therefore, can afford to invest without sacrificing our lifestyle. Consider the following scenario. Where an individual earns $2,000 in after-tax income but just $22,100 in debt at an average rate of 14.5%, her cash dilution rate is a startling 13.35%. What this means is that the debtor keeps only $1,732.86. To better appreciate the severity of her situation, let's assume that her financial advisors encourages her to invest $250 per month. This further reduces her already diluted after-tax dollars to less than $1,500. While she started out with $2,000, she now has 25% to enjoy her lifestyle. However, if this individual could eliminate all of her debt, the $267.14 in monthly savings could be earmarked for her investments. What damage does this cause to her long-term savings? That depends because there are two ways to tackle this scenario. In the first case, this investor might find that an additional $250 per month to invest is, in fact, not much of a sacrifice. If this is the case, then that additional $250 should still go toward repaying debt (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). This would reduce the debt even faster, from a little more than 57 months until full repayment without using the extra $250, to a little less than 35 months if she uses that $250 to repay the debt. Once all of the debt is repaid, the $250 + $267.14 can be invested for a total investment value 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. Another way to look at this is to assume that after nearly three years of paying $517.14, she wants to start enjoying more of her life and decides that instead of investing $267.14 (what she saves in credit payments) plus the full $250, she invests only one half of the $250 and spends the other $125 on something frivolous (like shoes). Spending $125 on shoes allows just $392.14 to be invested. Taking into account that she starts investing three years later, she would still come out farther ahead than if she invested $250 per month today (she would be ahead to the tune of $7,167, it turns out). 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. DISCLAIMER: This article is provided as information only and is not to be taken as financial advice. 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. |