The Million Dollar Question of Personal Finance: Should I pay down debt or invest? What if you could do both?
Traditional personal finance tells us to choose between paying down debt or saving and investing. The conversation usually goes like this, “Does the interest rate on your debt exceed the returns you could get investing in the market?”
For example, if you have a credit card at 20% interest, it would be in your best interest, no pun intended, to pay off your credit card because there are not many investments which will return 20% or more.
In another example, if you have an auto loan at 4%, it might be better to invest your cash in the stock market or other investments because you can earn higher returns than 4%. The stock market has historically returned 7-8% on average over the last century.
By investing in the stock market, you can theoretically grow your wealth 3-4% more than by paying off debt.
To pay off debt or save and invest is the million dollar question of personal finance. What can I do to prudently grow my wealth?
“Wealth is the ability to fully experience life.” – Henry David Thoreau
Benefits of Paying Down Debt
First, let’s start this section off by talking about mortgages: The word mortgage is derived from a “Law French” term used by English lawyers in the Middle Ages meaning “death pledge“, and refers to the pledge ending when either the obligation is fulfilled or the property is taken through foreclosure.
Literally, mortgage = death pledge.
“A man in debt is so far a slave.” – Ralph Waldo Emerson
Debt is mentally draining, financially draining, and affects your entire life if you are weighed down by the large barbell of debt.
The main benefit to paying down debt is increased cash flow. No more giving your hard earned cash to those pesky lenders!
If you choose to pay down debt, you will want to put extra cash towards your debt each month. This will increase the speed at which you pay down your debt.
By sacrificing short term and putting extra cash towards your debt, you can eliminate those debts in a much shorter time frame and pay off your debt fast. In addition, by paying off your debt faster, you will save money on interest!
Let’s do an example together.
Let’s say you have a $20,000 loan with a 6% interest rate and a 10 year term. Using an online calculator, your monthly payment will be $222.04.
Over 10 years (120 months), this will cost you $6,867.01 in interest. If you pay $100 extra a month, you can cut the time you are paying off your debt to 6.25 years (75 months) and you will pay $4,008.09 in interest. By paying an extra $100 a month, you will save yourself $2,858.92 and will be debt-free 3.75 years ahead of schedule!
As shown above, by paying extra each month, you can save money and reduce the amount of time you are paying off your debt. In addition, once the debt is gone you effectively give yourself a raise; you have more money falling to the bottom line each month for you to save, invest, donate, spend, etc.
Benefits of Investing
“Risk comes from not knowing what you’re doing.” – Warren Buffett
Really, investing can be as simple as you want it to be. Investing is not gambling. Investing consists of buying assets which have value and have the potential to appreciate in value over time.
If you are interested in investing in the stock market, you have the capability to invest in low cost index funds. These index funds will “mirror” the market. As I mentioned above, the stock market has historically returned 7-8% on average over the last century. If you invest $10,000 a year in index funds for 30 years and get 8% returns, you will have a portfolio worth $1.2 million!
Vanguard has many excellent options if you want to diversify index funds (domestic stocks and bonds, dividend growth stocks, international stocks and bonds, etc.).
If you don’t want to invest in the stock market, and would prefer to invest in real estate through rental properties, you can do that. There are many advantages to investing in real estate. Why do I love real estate as an investment class? Real estate is:
- Accessible – Anyone can buy it
- Appreciable – Can increase in value over time
- Leverageable – You can buy on margin and borrow against equity
- Rentable – Cash flow baby!
- Improvable – Through sweat equity or contracting out
- Deductible/Depreciable/Deferrable – Amazing tax benefits
Other Investment Options
Or if you don’t want to invest in either the stock or rental market, you could start a blog and look to build a business online! There are 7 billion people in the world, do you think you can carve out a niche for yourself and your business?
Again, there are many investment strategies out there. Personally, I believe rental properties offer many long term wealth building benefits. I also believe there are many benefits from holding low cost index funds.
If you want to read more on investing, please take a look at the following books:
- How to Think About Money (book review)
- The Richest Man in Babylon
- The Millionaire Next Door: The Surprising Secrets of America’s Wealthy
- The 4-Hour Workweek: Escape 9-5, Live Anywhere, and Join the New Rich
- Money: Master the Game (book review)
- Think And Grow Rich
- The Intelligent Investor: The Definitive Book on Value Investing.
- How to Win Friends & Influence People
- Rich Dad Poor Dad
Should You Pay Down Debt or Invest?
There are many questions to ask when thinking about making decisions related to personal finance.
Before asking yourself the million dollar question of personal finance, should you pay off debt or invest, you should ask yourself the following questions:
- Do you have enough money each month to cover your debt payments? Do you have additional money at the end of each month to invest?
- How much debt do you have? What are the interest rates? Do you feel debt has a grip on your life or finances?
- If you have extra money available to you, will you actually invest it? Or will you spend it?
- Do you have an emergency fund?
- What are the terms of your debt? Are there any penalties for prepayment? Is your interest rate adjustable?
Once you are able to answer the questions above, it will be easier to decide whether to pay off debt fast or to invest.
Remember the golden rule: the person who has the gold makes the rules. – Unknown