06 Apr When to Invest vs. Paying Off Debt
Are you facing a dilemma right now, debating whether you should invest vs. paying off debt? That can be a tricky subject, but we are here to help! It takes a little bit of math, but don’t worry; we will walk you through it!
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Understanding the Market
Before we can tell you whether to invest or pay off debt, we must first compare rates of return (the amount earned or lost on the investment). Let’s take a look at the S&P 500 Index. First, what the heck is that? The S&P 500 is a stock market index that calculates the value to the 500 largest companies traded on the U.S. stock market. Most analysts consider the S&P 500 to be a good gauge of how the market is performing. We are going to look at the S&P 500 since 1928, which is almost a century worth of data!
As you can see, the stock market goes up (green) and down (red) A LOT! It looks more like a roller coaster than a pretty upward curve. Yet, if you look carefully, you will see that there is a lot more green than red.
What this means is that the market is actually steadily rising (even though it doesn’t look like it). In the end, after averaging out all the highs and lows, the S&P 500 has an average annual rate of return of 10%. To reiterate, this means that if you were to put money in the market for YEARS, it would have an average annual growth of 10% (keeping in mind that it will go up and down a bunch to get there).
What does this have to do with debt? Excellent question! We like to crunch numbers, remember? That means that we need to have something to compare with the debt. We know that the average (best case scenario) we can make on the stock market is 10%, but let’s be safe and give ourselves a 2% wiggle room and assume that we are more likely to average around 8%. Now, we are going to look at two examples to give you a real-life situation of this works.
Debt Example One:
Our first example is our favorite imaginary friend, Jill Oaks. Jill recently purchased her first home. Congrats Jill! After paying her down payment, Jill signed a 30-year loan from her local bank with a 5% interest rate. Jill has a good job and is able to make all of her monthly payments. Plus, she is an excellent cost-cutter, so she has extra money at the end of the month. She has already maxed out her 401(k) and her IRA, has built up a substantial emergency fund, and has no other current debt. So now she is trying to figure out what to do with the extra money. Should she pay off her mortgage debt, or should she invest?
Thinking back to that number crunching we did a minute ago, she knows that if she were to invest her money in the market long-term, she could earn 8% (or maybe even up to 10%) back. To make this a super simple math equation, we will subtract her debt from her possible return on investment (ROI).
8% ROI – 5% Debt = 3% Gain
Therefore, Jill will increase her overall net worth more by investing in the market than she would be paying off her debt. So, what should she do? Jill should continue making her minimum mortgage payments and invest her extra money in the market.
Debt Example Two:
Example two is our other imaginary friend, Davey Detter. Davey recently went on a snowboarding vacation with his buddies, even though he couldn’t afford it. He put everything on his credit card and racked up a $4,000 debt. The credit card that he put it on has a 15% interest rate. Davey has a decent job and has money in his account. However, he needs that money to pay for rent, groceries, and other living expenses. Like Jill, Davey has his 401(k) on track for maxing out, has a built-up emergency fund, and has no other debt.
Now, Davey really doesn’t like being in debt, but he doesn’t want to use his emergency fund money, because this isn’t an emergency. Due to this, Davey re-evaluated his monthly expenses, set a new budget, and implemented some cost-cutting techniques. He now has extra cash at the end of each month, so he is trying to decide if he should pay off his debt or invest it?
We are going to go back to that same simple formula we used for Jill. We will subtract Davey’s debt from his possible ROI.
8% ROI – 15% Debt = -7% Loss
In this case, investing is NOT the way to go. Even if Davey invests and gets 8% or even 10% ROI, it won’t be enough to increase his net worth than paying off his debt. In most cases where you have high-interest debt, you will likely want to pay that off first before investing. This applies to Davey as well. What Davey needs to do is pay off his credit card debt as quickly as possible. Once it is all paid off, then he can think about investing.
When to Invest vs. Pay Off Debt
As you can see, the easiest way to tell if you should pay off your debt or invest is in the numbers. You just need to determine which method will increase your overall net worth the most, which you can quickly determine by looking at your interest rates on your existing loans.
If you decide that paying off your debt is the better option, try these methods to conquer your debt even faster!