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The following post is by MPFJ staff writer, Kevin Mercadante, who is a professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has a background in both accounting and the mortgage industry.
This is one of the most common – and complicated – questions in personal finance. If you have debt, should you pay it off before you begin investing? Or, should you concentrate your efforts on investing while gradually paying off your debts in the normal course?
There are compelling reasons in both directions, and which you choose may have more to do with personal circumstances and preferences than anything else. Let’s take a look at both.
Investing first and paying off debt gradually or later
There are solid reasons to favor investing as early in your life as possible–even if you have substantial debt.
Investing early leads to a larger portfolio. It is a fact that the earlier you begin investing, the faster you will build a large investment portfolio. The best way to demonstrate this is by example:
Investor #1 begins investing $5,000 each year beginning at age 25. With an average annual rate of investment return of 8%, by the time he turns 45, he’ll have accumulated $238,610.
Investor #2 begins investing $10,000 each year beginning at age 35. Also having an average annual rate of investment return of 8%, by the time he turns 4,5 he’ll have $151,069.
The two investors have each saved $100,000, and achieved an investment rate of return of 8%, but Investor #1 has $87,541 more in his portfolio – which is about 58% more. So, why the big difference in portfolio size by age 45? The time value of money! Investor #1 had an extra ten years of that 8% rate of return, and it made all the difference.
That’s what you get going in your favor when you begin investing early.
An investment portfolio creates a sense of financial stability. One of the biggest benefits of having an investment portfolio early in life is that it provides a cushion that gives a sense of financial stability. You will face different challenges in life, and all will be easier to deal with when you have some money behind you. An investment portfolio gives you financial strength and that can get carry through into nearly everything else you do.
Even if you have debts to pay, those debts will seem smaller and easier to pay if you have an investment portfolio already established and growing. You’ll be shrinking your debts, while you are growing your investments. And, by the time your debts are finally paid off, you will have an investment portfolio to build on – you won’t have to start from scratch.
Grow your way out of debt. There is a way of paying off debt that’s easier than making extra principal payments. If you at least make the minimum payments on your debts, and slowly reduce them, while you’re building your investment portfolio, you will eventually be in a position where your investment pile will be bigger than your debt pile. Rather than paying your debts off little by little, you can then pay them off simply by writing a check.
Let’s say for example, that you have $20,000 worth of debt and zero investments. Five years later you still have $15,000 in debt, but you also have $40,000 in investments. At that point, you can pay off your debts and still have $25,000 in your investment portfolio.
In this scenario, you have two financial goals: to invest money and to payoff your debts.
But, you chose to focus on only one of them – investing money. But, along the way, you accumulated enough money that you were not only building your investment portfolio, but you are also building up enough money to payoff your debts too. In a way, you ignored your debts in favor of your investments, but ended up achieving both goals anyway.
Paying off debt first and investing later
There are also compelling reasons for paying off debt first, then investing later.
Guaranteed rate of return. The rate of return on investments doesn’t stay in one place. One year, you can earn 5% on your money, the next you can earn 10%, and the following year you could take a loss of 7%. But with debt, if you’re paying 10%, that rate will generally be the same no matter what. By paying off the debt, you’ll be locking in a rate of return of 10% – that’s 10% that you won’t be paying on the money you owe. That’s a guaranteed rate of return that you could never find in the investment markets.
Even if you invest your money in fixed income vehicles, you can never match the rate that you will be paying on your debts. That’s because debt carries an interest rate that’s always higher than what the banks will pay you on money you invest with them (it it wasn’t, the financial companies wouldn’t be making any money!).
Investment markets fluctuate – debt doesn‘t. When you invest money in the financial markets, whether it’s in stocks, mutual funds, ETFs, commodities or even real estate – the value of those investments will always fluctuate. Sometimes they’re higher, sometimes they’re lower, but they seldom stay in one place. In the event of a prolonged decline in a financial market you could lose a significant portion of your investment value for several years.
This is not true when it comes to debt. The amount of money you owe on a debt is fixed, except for that portion which you have paid down. If you put your extra money into investments, rather than into debt payment, you could see the value of those investments drop while your debts owed would still be the same. If that were to happen, then paying off your debts would be the better investment.
Paying off debt leads to more money to invest. Perhaps the biggest advantage of paying off debt is that it will leave you with more money to invest. If you try to invest money while you are still paying off debts, it may be difficult to save a significant amount of money. There may even be times when you have very little money to save and invest at all. But once your debts are paid all of your extra money can be poured into your investment portfolio.
This allows you to concentrate all of your efforts on one goal at a time. Initially, you’re putting all of your money into debt repayment, and that should allow you to payoff your debts much quicker. Once that goal is achieved, 100% of your money can then go into your investment portfolio to build that quickly. Divide and conquer at it’s best!
What about your mortgage?
If you decide that you want to payoff your debts before you begin investing, should that include paying off your mortgage? Probably not.
Mortgage debt is different from other types of debt in two important ways. First, it is secured by a major asset – your house. That’s also an investment; in a real way this is a debt that you maintain in order to own a major investment.
The second factor is the length of the loan. Mortgage loans typically run from 15 to 30 years in length. If you have to wait that long in order to begin investing money, most of the advantages of investing will be lost. Even if you were to pay off your mortgage in only 10 to 20 years, too much time will have been lost to make up for the benefit gained. Once again, it’s the time value of money at work.
A couple of other factors to consider in connection with a mortgage are that 1) interest rates on mortgages are usually the lowest loan rates possible, and 2) mortgage interest is tax-deductible. Both remove much of the urgency normally attached to paying off debt.
Which do you think you should do first, pay off your debt or invest?
***Photo courtesy of http://www.flickr.com/photos/68751915@N05/6793832171/sizes/l/in/photostream/