Pay Off Debt or Invest?
More often than not, financial conversations with individuals or families tend to follow similar trends. For instance, when I do a “fact-finder” with a couple, I can almost always pinpoint who is the manager of the money and who is the one to ask, “hey, do we have enough money for me to purchase __________.” Or how people approach their money based off the debt they have or how many asset classes they are actively funding and managing.
What I mean is, almost every conversation that is financially related is very “either/or,” instead of being a mix of everything. Now, I’ll be the first to admit that trying to do a little for a lot can sometimes hinder your route as you navigate an increasingly expensive world. However, I think there is also something to be said for hammering down in one direction to enhance a different aspect of your finances.
So, with that being said, here’s a few things to consider when deciding whether to pay off debt or invest—or both!
Interest Cost vs. Interest Earned
This is the most common conversation revolving this topic because,
1. It’s a valid conversation
2. It’s the easiest way to debunk one another from a relative perspective
Here’s what I mean:
If someone is hardcore debt pay down, no debt is good debt, all debt is bad, with a Dave Ramsey mural hanging over their fireplace—the interest cost argument will be their go-to, in an attempt to debunk why you should pay off debt before investing a single penny.
On the flip side, the interest earned argument coming from the Dogecoin investing, Robinhood worshipping, Motley Fool subscribing, Wolf of Wall Street quoting friend named Chad from Alpha Epsilon Pi—yes I googled that... although I come off as a frat star, I was a football player—they’ll always default to the interest earned rebuttal.
All blame aside, the general idea around Interest Cost vs. Interest Earned involves finding the net financial results of the reduced interest you’d pay on your debt versus the interest you’d earn if you invested your disposable income, no matter how big or small.
For instance, let’s say your disposable income is $250 per month—we’ll start here.
Now let’s assume you have a $5,000 balance on a personal loan that is at 8% interest and your monthly minimum payment is an even $100. If you were to pay the minimum on this particular loan, it’d take you 5 years and 2 months to pay this off in full and you’d pay $1,102 in interest alone. So, in reality, your loan ended up costing you $6,102.
Now let’s assume on that same personal loan, you directed your extra $250 of disposable income towards paying down that loan faster. This means that now, on the same note, you’re putting a total of $350 towards that personal loan (minimum required + disposable income). You’re not paying that same note off in 1 year and 4 months and you only paid $272 in total interest, saving you $830 in interest.
Let’s now look at investing or saving that $250 of disposable income.
Although it’s a falsification of actual yield, I’m going to use the 8% rule for the investing conversation—believe me, your buddy Chad would throw that number at you because he doesn’t understand net yield anyway.
Instead of paying down debt, you decide to invest the disposable income of $250 into an account earning 8%. You do this every month for a year. After a year’s time, you’d have earned $108.47 of interest, plus you’d have your principal amount of $3,000, giving you $3,108.47 in said account.
At the end of the day, run your numbers on this one. You could split it (the $250) in half and go after both, just remember your savings won’t be as high and your debt won’t be as low. In my professional opinion, it’s a fairly layered conversation because your month-to-month situation will determine the direction you go or deciding that you can do both and be happy with it. Either way, just decide and GO!
The 4% Rule
No, I’m not talking the withdrawal rate in retirement. In fact, I think that rule needs to be debunked, so I’ll be sure to write on that next!
I’m talking about the 4% or less interest rate on debt, rule. The 4% interest rate rule basically means that if you have debt accounts that have less than a 4% interest rate, you’re likely not losing as much in interest as you’d think and thus, shouldn’t sweat the debt pay down.
*Dave Ramsey and Suzie Orman scream*
Yes, I know, all debt is “bad,” but hear me out on this.
Remember the example we just went over with the $250 of disposable income? The interest lost on 8% of a $5,000 loan would be roughly $1,102 over the course of 5 years and 2 months—equating to roughly $17 and some change monthly. At a 4% interest rate on the same note, you’re looking at paying off the loan in 4 years and 7 months and losing $479 to interest alone, or $8.71 per month. So, in reality, the interest lost on this particular loan isn’t really that bad—I’d “invest the rest” in this particular situation.
*Dave Ramsey sues me for using his low-brow lingo*
What I will say about putting laser focus on eliminating debt at all costs is the fact that you are pursuing a better monthly output. Meaning, you’re increasing your cash flow (in the future) by getting rid of the monthly payments on said debt. The only downfall I see is if you’re laser-focused on eliminating debt and neglecting your retirement accounts or savings, you’re only suffocating your future savings amount.
*Dave Ramsey cheers*
Again, it really depends on where you’re at with your cash flow. In the original example, the household I’m describing is fairly tight financially, seeing as they only have $250 of disposable income. However, if you’re aligned in all other areas, you’re probably more apt to invest, rather than be in a hurry to get rid of a debt with a 4% (or less) interest rate.
Do the numbers and don’t be lazy on this particular area of finance. It’s not difficult to find a calculator on Google—that’s how I calculated these numbers so cleanly.
What Do You Want?
If you have a partner, ask the question, “what do we want?”
I mentioned it earlier, but I think it’s important to note that in almost all cases, people approach finance as an either/or, black/white, pineapple on pizza or it should be outlawed to have pineapple on pizza sort of discussion. THIS OR THAT!
Synchronicity is important in financial decisions-- and I'd assume in marriage as well.
Do you align with what you truly want or not? If your goal is to retire by 40 but you aren’t actively investing in a number of different areas and bring home $36,000 a year, I’d highly recommend doing some personal development first, but also understanding that that simply isn’t possible if you’re trying to eliminate debt first and not investing.
That being said, you couldn’t invest enough into the market, real estate, or crypto combined to retire at 40 when you’re bringing in $36,000 a year. If I was consulting with you, I’d recommend finding ways to make more money first, then decide which asset classes can help you reach that goal.
That was a fairly loose example, but you get it. You wouldn’t set a goal to lose 100 pounds, work out two times a week, not change your diet, and expect to achieve that goal in one year.
It’s not possible!
What would be possible would be to set a goal to lose 100 pounds, work out 4-5 times a week, change your eating habits and take in more nutritionally dense foods, and set a realistic timeline of 18-24 months and put the plan in motion.
That’s possible and achievable.
Moreover, when staring down a goal, you have to align with that goal. People who sit around all day and eat potato chips and drink soda by the liter likely won’t reach their goal of losing 100 pounds. Just like someone who wants to be retired and live comfortably by the age of 40 probably shouldn’t be relying on $36,000 of active income and $250 in their Robinhood app getting them to retirement.
It takes alignment!
Even more, it takes action!
You have to go do it. You can’t say you want something then be mad that you don’t get it if you haven’t worked towards it. But this is where—I’ll say it—people lack self-awareness. It’s not just my generation of millennials that have ruined expectations and reality, it’s the entitlement mentality that plagues this beautiful country we live in that is the United States of America-- of all ages by the way.
Improve your self-awareness and decide what you actually want and go get it. There’s never been a time in the history of the world that you were at an advantage more than you are in 2021.
First off, that got passionate, real quick. However, these are the things I want to say to some of the people we consult with, but at the end of the day, there’s a level of empathy and professionalism that needs to stand taller than my own opinions and belief systems. I truly have a love for this country and a love for seeing people win and win big, that's what drives me to do what I do.
You are in control of your life and the trajectory you choose to be on. Whether it be as simple as paying off debt sooner or raising capital for that incredible business idea you have, promise to yourself you’ll be real with where you are, where you want to be, and where you’re headed.
The rest will simply take care of itself!