Age Old Question: Invest or Pay Off Debt

Ever wonder why so many financial advisors push you to start saving right now, even if you are burdened with insurmountable debt? The answer is simple: Financial advisors are commissioned salespeople. If you don’t buy what they sell (the investments) they don’t get their commission (trailer fees).

Of course, the power of compounding plays a small role in the “invest early” motto that so many Financial Advisors promote. But what does this do to your lifestyle? Your debt repayment plans?

One way to see whether it makes more sense to invest now or start later (after all of your debt has been repaid) is to measure your Cash Dilution Rate. What this rate tells us is how much we lose to our creditors for every $100 we earn. The higher your Cash Dilution Rate, the more it makes sense to repay your debt before committing to a true investment program.

Taking a closer look, we can consider someone who earns $2,000 in after-tax income. Match this to the average American debt of $22,100 that carries an average rate of 13.35%, and this individuals sees only $1,732.86 of her $2,000.

For a better appreciation of this situation and how severe it can be, let’s pretend her advisor encourages her to invest a “modest” $250 per month. Combined with the $267.14 she pays in credit debt, she is left with less than $1,500 to enjoy the rest of her life. Even though she started with $2,000 she loses an additional 25% and has much less to pay for other expenses like rent, mortgage, entertainment, etc.

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.

Assuming the investor has 15 years left to invest and can still afford it after the debt is fully repaid, to invest $250 + $267.14 (or $517.14) monthly, then she will be farther ahead by $38,283… and this takes into account that she starts investing 3 years later than she would have if she had started with $250/month! Not only will this investor have no debt left to repay three years later, but she will be farther ahead and better prepared to weather unplanned financial hardship.

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).

Either way, repaying debt should take priority in nearly every sound financial plan, even though repaying debt is much less glamorous and nowhere near as exciting. Of course, there are some instances and arguments where debt repayment might not always be the wisest decision, but those situations are quite rate.

Originally posted 2009-06-03 07:55:37.

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Tags: credit, credit card debt, credit card debt repayment, credit debt, debt repayment, finances, pay off debt, personal finances