Numerous financial advisors and planners will tell you to start investing early in your career. After all, the sooner you invest, the more time your money has to grow. Can you disagree with this logic?
The Rule of 72 declares that the amount of interest you are earning divided by 72 will give you the number of years it will take to double your money. For instance, if you are earning ten percent a year, it will take you roughly 7 years and a few months to double your money. Not too shabby!
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But what if your investments aren't earning a return that is greater than what you are paying out? For instance, if you are maintaining a credit card balance charging you 12% a year, yet your returns are averaging 8% a year, you may think you are losing 4% (12-8 in case you hate math!). SPOILER ALERT: You are losing more than 4%!
The primary goal of investing is to beat and exceed inflation. Currently, as of the writing for this blog, the annual inflation rate is 2%. This means to keep pace with inflation while paying on the credit card interest of 12% in our example above, your investments need to be earning 14% a year just to keep pace. Ouch! Yet, I come across many clients who will argue back, "But I am still earning 8% a year on my returns!" Sadly, these clients aren't considering taxes, fees, and inflation.
At this point, you are thinking "Where am I going to earn 14% a year if I am paying out 12%?" and it's a valid question.
If you are in this situation, you need to ignore the financial gurus because they are misleading you. Your primary goal is to pay off this debt quickly so you can turn those outgoing credit card payments towards your investments.
To pay off your debt quickly and efficiently, read our blog: Debt Stacking
What If Debt Interest is Same as My Investments?
For another scenario, let's state you are paying 6% per year on your debt due to interest. This can be from a mortgage to an automobile. If you are earning 8% annum on your investments, are you including the loss of purchasing power? You are really breaking even because 8% - 2% inflation is 6% obviously. We have seen some really solid returns lately in the stock market but these returns seen lately in the double digits occur in statistical outliers and are not the norms. Therefore, expect the returns to dip below 10% eventually.
If you are in this situation, determine how long it can take you to pay off these debts. With a mortgage of more than 10 years, strive to pay off early but I would bless you investing while paying a mortgage because a home gives you an equity return. An automobile declines in value rapidly and the equity is minimal.
For any other debt that exceeds what you can earn in the financial markets, your goal has to be paying down any balances as quickly as possible. The debt snowball method has proven time again to be effective because it frees up capital quickly to pay down other debts. Read Debt Snowball: Payoff Debt the Smart Way
There are occasions where investing first before paying down debt makes sense such as credit cards offering 0% interest until 2020. By taking advantage of these offers and transferring balances over or paying the minimum amount each month, you won't accumulate any interest charges. Just pay attention to any fees that may occur. At this point, you can invest the difference into a brokerage account or max out your IRA early.
It's a numbers game but you must be on watch to always be taking advantage of the best possible deals. There are many sites on the web to browse current credit rates and offers plus we have seen businesses take a similar approach.
Last decade, we witnessed corporations taking on billions in debt. The reason many of these businesses were doing this was that it was literally cheaper to take in new debt while investing it to make more money. With banks charging them 1% interest for loans, corporations were using these funds to earn anywhere from 5-12% a year, depending on the type of business.
Being Responsible with Debt
This strategy isn't for everyone. If you are not good at managing your money, aren't paying your bills on time, and not maintaining a budget on a regular basis, then you need to avoid this method all together because it is likely you'll just find yourself in a financial situation that isn't pleasant. These tips and recommendations are only for those who manage their money responsibly.
Take a deep dive look into your finances this week and compare the interest rates you are paying out to the return of your investments. Next, develop a strategy that can help you get ahead. This strategy may be to get out of debt quickly or if you are debt free, it may be to invest more in your investment accounts.