If everyone waited until their debt was paid off before investing, many of us wouldn’t start investing for a LONG time, if ever - and what do we know about investing? TIME IN the market is key to reaching financial freedom #compoundinterest.
Here are a few things to consider before starting a taxable brokerage account:
1: Create an emergency fund that you are comfortable with (typically 3-6 mo of expenses)
2: Pay off high interest debt - this is what this blog post is all about
3: Maximize your tax advantaged retirement accounts (example: 401k & Roth IRA) - However, I do believe if you have an employee match, start that while paying off high-interest debt.
Today, I am going to focus on #2.
So here is the number one thing that I think you should consider when you’re analyzing your debt:
Does your debt have high interest? Meaning, if your debt interest is higher than 7%, you should focus on your debt. If it is lower than 4%, your money could go further in the market. In between 4-7%? It’s up to you - paying off debt feels good, but you could also make more money in the market with those interest rates.
Why is interest 7% or higher considered high interest debt?
It is unlikely that you will find a stock that will consistently outperform what that high interest debt is costing you. For instance, the average stock market return since the S&P’s 500’s inception (in 1926) is approximately 10-11%. And although that is much higher than 7%, when we adjust it for inflation, it is closer to about 7%.
The S&P 500 is a stock market index that measures the performance of 500 companies in the US. It is responsible for driving most of the growth in the total market which is why I am using it as a reference.
If we shorten the period to the last 20 years – where we have experienced major, life changing events like the terrorist attacks in 2001, the financial crisis in 2008… and oh yeah, the global pandemic – we have still seen about a 6% return.
What does that tell me? The market is resilient. And history tells us, that the longer we hold, the greater returns we will see. Because time in the market is so important, we can’t allow debt to stop us from investing, but we can still be smart with our debt and investing.
If you have debt, you are not alone.
In fact, according to CNBC, the average American debt totals $90,460. We must keep in mind that all debt is not bad debt. Debt can be used as leverage, or it can be your greatest downfall. In fact, I use debt as a major tool in real estate investing. Take a moment to analyze each form of debt you have.
What kind of debt is there?
The most common forms of debt are:
Mortgages Student Loans Credit Cards Auto Loans Personal Loans Medical Loans
Once you have pinpointed your debts, analyze each one and find out what the interest rates are. If you have high interest rate debts, then those loans should be your priority.
How should you strategize?
I know the feeling of wanting to invest sooner but crippling high-interest debt slowed down the process (when it came to the stock market, real estate is a different story – stay tuned for a blog post).
There are many competing ideologies about debt payoff; however, some of them prioritize the psychological satisfaction of paying off a loan over basic math *cough Dave Ramsey cough*.
Dave Ramsey, for instance, likes to focus on paying off your smallest debts first for a *PsYcHoLoGiCaL* win. Not to downplay the psychological satisfaction of paying off loans, trust me, I understand the feeling, but what if you understood how paying off your loans little by little was actually making you more money? There's a psychological win in that as well.
We are smarter. We like to pay off high interest debt for a money win and then we like to invest along side of our low-interest debt.
If people were listening to Dave Ramsey right now, they could be focusing on paying off their smallest Federal Student Loan right now that is accumulating 0% interest (FREE MONEY), instead of taking advantage of the times and focusing on a high interest credit card debt (roughly 17.99% interest or so).
Before going over solutions, let’s do some math to understand how paying off debt faster looks.
Get ready for a lot of math and a lot of digesting.
Let’s focus on two common debt situations: student loans & credit cards.
Debt: $28,400 Term: 10 years Interest Rate: 4.66% Monthly Payment: $297
This student loan has a lifetime cost of $35,583 paid over 10 years. In other words, borrowing $28,400 costs you $7,183.
If you were to pay $200 extra towards the monthly PRINCIPAL (key term), your loan would now cost $497/mo instead the minimum payment of $297. You would have the loan paid off in 6 years instead of 10 years and the $28,400 would cost you $3,859 instead of $7,183. Therefore, increasing your payment by $200 shaved off 4 years and saved you $3,324 of interest. This is the power of over paying the minimum amount towards your principal loan amount.
Now, because this example of a student loan is under the threshold of what we call a high interest debt, you could still pay the minimum and invest the hypothetical $200 you have laying around instead of overpaying on the loan.
So, let’s say you invest the $200/mo into a low-cost, diversified index fund that averages an 8% return for the same 10 years that you are paying off that student loan. Your hypothetical investment would be worth $37,033 after 10 years. You would have contributed $24,000 (with your $200/mo), and the total interest earned would be $12,833.
As you can see, in this situation, investing the $200 a month for 10 years made $12,833, while overpaying the loan saved you $3,324.
Math tells me making $12,833 is better than saving $3,324.
I don’t know about you, but in this situation, investing the extra made more sense than overpaying the low-interest loan.
You can also choose to be more conservative with your returns (5-6%) to truly see if you want to invest, or pay off loans faster. Here is the calculator you can play around with.
On to the next situation:
Credit Card: Here is a calculator for your scenario.
Debt: $6,000 Interest Rate: 18.99% Minimum Payment: $130
The lifetime of this loan would be 7 years with a minimum payment of $130. It would cost you $4,852 in interest to borrow $6,000 – 45% of the entire loan is interest. Yikes, read that again. Credit cards can be your biggest tool for free money and free trips, or a nightmare - don't worry, I will teach you how.
Keep in mind, this is if you never spend on this credit card again in those 7 years (84 months).
If you were to double your payment to $260/mo, it would take 29 months to pay off instead of the 84 months. The $6,000 loan would then cost you $1,525 in interest (about 20% paid in interest).
Therefore, doubling your payment, you would reduce the loan by 55 months & save $3,327.
Now, let’s take the investing standpoint on this case. If you choose to invest the additional payment of $130 into a low-cost, diversified index fund for those same 7 years at an 8% return, your hypothetical investment would be worth $14,802.
Your total contributions to the index fund would be $10,920 (from your $130/mo payments) and your total interest earned would be $3,752. Looking back at the loan where you are making $130 minimum monthly payments, the interest would be costing you $4,852 in those 7 years.
Prioritizing investing the additional income over paying extra on the minimum credit card would be a loss of $1,100.
This is why INTEREST RATES ARE POWERFUL AND A PRIORITY.
Why is this important?
The above illustration should show you:
1: Paying more than the minimum reduces the LENGTH of the loan 2: Paying more than the minimum reduces the AMOUNT OF INTEREST you pay 3: It is still worth investing if you have low-interest debt AND no high interest debt (this is separate from my thoughts on real estate investing) 4: High interest debt is the priority
Side note: Using credit cards the wrong way can cost you thousands of dollars – that on sale $20 t-shirt you bought with your card but didn’t pay back in full the same month? Well, at the end of the day, you may have ended up paying more than full price because of your credit card interest. Credit cards are not FREE money. It is borrowed money - and you're buying it at the highest interest rates there are. (blog post coming soon on how to properly use credit cards to get cash back and free vacations).
Next steps.
Everything in life is negotiable. If you can get better rates, no matter your current interest rates, try.
Here are two ways to get better rates:
1: Refinance (student loans, mortgages, auto loans, personal loans) – keep in mind the FEES, if any, associated with refinancing before moving forward 2: Negotiate rates and fees (credit cards)
If you have student loans, I recommend earnest to refinance. I used Earnest for my student loans and they went from a 6.5% interest down to a 2.56% interest - FIXED interest, not variable. My total interest paid over the 6 year term will be $1,200. This allows me to leverage my debt because the cost of borrowing is so low. Now, I can keep my capital to invest in real estate and the stock market etc instead of trying to rush and pay off this loan. (This is an affiliation link and I receive profit if you choose to refinance with the earnest link, but I would not recommend anything that I do not truly believe in. Please do your research to see if they will work best for you. If you do like Earnest, the link is a great, free way for you to support me and my content!).
The Takeaway
We understand that paying off debt efficiently will help in the long run. Start with the highest interest rate first and pay it off as fast as you can. Stop spending money on your accounts with high interest immediately, if possible. Any extra dollar you have should go to your highest-interest debt.
What all this boils down to is interest rates are KING. Whether we are looking at the interest rates to borrow, or the interest of returns, it matters.
Now, paying the minimum payments on any debt is only smart if you are investing the extra! Budget and see the extra income you have each month to prioritize how you can spend it.
I know this can feel overwhelming. At the end of the day, everything is just math.
The only way to start is to start. You got this!
If you need a little guidance, I am starting one-hour, one-on-one sessions that can assist you with this very thing. We can cover any topic you'd like - budgeting, planning, understanding credit cards, prioritizing debt, smart retirement moves, setting up your children for success - anything! The first 10 sessions scheduled will cost $59 but after that, it will increase to $149 so make sure you are on it! Click here if you're interested! We got this! I am so excited to help you change your life.