Everyone talks about the power of investing. You know you should be socking money away for your future, but how do you do that if you have debt?
Should you even bother investing while you are in debt?
This is a common question. With limited cash flow, it can be challenging to know exactly how to prioritize and make the best financial decisions for you.
On the other hand, failing to invest now means you are losing out on a huge opportunity to earn interest on your investments.
To compare investing versus paying off debt, consider this example. Say you are a recent college graduate with $20,000 in student loans. You are on a 10 year repayment plan. The interest rate is a typical 6 percent. To pay it off in 10 years, you will pay about $222 a month. If you take the whole 10 years to pay the loan, you will pay an additional $6,644 in interest. So, in total, you will pay $26,644 over 10 years.
Conversely, consider if you had $20,000 to invest and no debt. You invest all $20,000 at the age of 25. You don’t add any additional money to this account – the initial $20,000 is all you invested. With a modest 7 percent return, after 40 years, you would have around $300,000!
Or, to compare investing to the student loan debt example, let’s say you invested $20,000 for only 10 years, without any additional contributions, but earned the same 7 percent compounding interest rate. After 10 years, you would have over $39,000 – earning you $19,000 in just 10 years.
According to these calculations, the difference is clear. Debt may be pressing, but failing to invest can actually have more dire financial consequences.
With debt, you typically have a set term of when you will pay it off. For instance, you may have a 10-year student loan repayment, or a 15-year mortgage. Though they are long periods, debt only has to be temporary in any circumstance. But if you start investing while you’re young, you can have 30 to 40 years to accrue interest at least. Mathematically, it makes sense to invest.
To get started investing, even if you have debt, here are some things to consider.
Credit Card Debt
Credit card debt almost always has an extremely high interest rate, usually somewhere between 15 and 20 percent. Credit card companies aren’t in a big hurry for you to repay that debt, because they will be making a large profit for every month you owe them. They will only require you to pay a small minimum.
For anyone with credit card debt, it’s best to pay off the debt before investing. With such high interest rates, it simply makes it too difficult to get ahead with investing when you have credit card debt. The likely rate of return you may gain from investing won’t compare to the 20 percent interest rate of credit card debt.
So, before you start investing, pay off that credit card debt. To help in the repayment process, you may want to consider refinancing your debt to receive a much lower interest rate.
Related
Mortgage Debt
Mortgage rates have always been relatively low. Rates can vary anywhere from 3.50 to 7.39 percent, though they are usually on the lower end of that spectrum. With rates that low, you can almost guarantee a better return from the stock market.
Student Loans
With typical interest rates much higher than, say a mortgage, student loan rates aren’t nearly as high as credit cards. Though student loan interest rates can vary, they usually fall somewhere in between the other types of debts.
However, student loans are unique in that the consumers are typically recent college graduates. Recent college graduates have not yet reached their earning potential – so these loans can eat up a significant portion of that entry-level salary. Because of this, they may think it’s more worthwhile to pay off their student loans rapidly so they can free up more cash.
But, one thing recent college graduates do have working in their favor is time. Time is a huge advantage with regards to investing. Your student loans require you to be on a repayment plan, so you know if you are getting them paid off in 10 or 20 years based on your minimum monthly payment. Even if you pay the bare minimum – they will eventually be paid off.
Like we discussed in the example at the beginning of this post, time is an enormous benefit. The earlier you can start investing, the more years you are giving yourself to earn compound interest.
What if you could get a lower rate on your student loans? You can check out SoFi to get a free estimate of how much they can save you.
Note: Take extra caution before refinancing federal student loans, as you will be giving up your right to income-driven repayment plans and potential student loan forgiveness. With that being said, if you are certain you are going to pay back your loans in ten years or less and are comfortable giving up the additional rights that come with federal student loans, refinancing with a private lender could save you money.
In this case, it still would be helpful to invest even a few dollars a month to take advantage of the time you have available to you.
How Can You Pay Off Debt and Invest? Increase Your Cash Flow.
Many millennials want to invest and pay off debt, but have one major issue – cash flow. Their debt-to-income ratio may be higher, so they struggle to come up with the cash to invest.
If cash flow is a problem, there are two things you can do. You can do one or the other, although they are most powerful when you use both tactics.
You can decrease your expenses while increasing your income.
Decreasing your expenses is easy enough. Look at your budget to see if there is any spending area you can cut down.
Conversely, increasing your income is an incredibly powerful tool. You can make an extra $500 a month fairly easily – trust us, we have done it!
There are so many ways you can increase your income. Personally, I started freelance writing outside of my full-time job. I pocketed the cash and use that money to pay off debt and invest.
Whether you choose to start a blog, freelance write, babysit, sell on Etsy, or some other side hustle, there really is no limit to what you can earn. And it makes all the difference.
Consider Your Emotions
As someone with student loan debt, I empathize with how demoralizing debt can be. I wouldn’t recommend that anyone should dive into investing if you don’t have control over your current debt.
How you feel about your finances undoubtedly will affect your priorities. Most of us are consumed with the idea of what we owe, instead of thinking about what we could potentially gain.
One tip that was helpful for me was to shift my mindset. Instead of focusing all of my energy on my student loan debt (which can be demoralizing), I started looking at my net worth. Before I started investing, I had a negative net worth – with no property to my name, my student loans were all I had to consider. I will admit, looking at my net worth for the first time was fairly depressing. If I was only paying off my student loan debt and not investing, my net worth would be increasing, but very, very slowly.
However, since I prioritized investing while paying off my debt, my net worth has been increasing much more quickly. I took advantage of the time available to me, and worked to increase my cash flow through side hustles so I could pay off my debt and invest.
Stay Out of Debt
Obviously, you can’t make any progress if you keep accumulating more debt. If you have massive student loan debt or excessive credit card debt, it probably makes more sense mathematically to pay those off first, or at least pay them down before you start investing and building wealth.
An emergency fund is a must for anyone who wants to stay out of debt. With an emergency fund, you are prepared for nearly any unexpected event that may happen to you, such as if your car breaks down or you have high medical bills. Instead of relying on credit cards to carry you through a tight period, start an emergency fund.
What’s your opinion: Do you think you should invest when you have debt? Why or why not?
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I definitely think you should at least invest in things that have a guaranteed rate higher than your debt – typically, this is the 401k match offered by employers, but it could also be anything if you happen to have a 0% loan.
Another consideration is that some (if not all) tax-advantaged accounts (401ks, IRAs, etc) have a yearly max. If you wait until you’re done paying off debt before investing into those, you may not be able to put as much into them as you would like.
That’s a great point – there really is a limit to how much catching up you can do. It’s easy to get super-focused on things like debt, but there are so many other long-term financial implications to consider.
Increasing my cash flow helped things tremendously. Sure, you can be frugal, pay on your debt, and invest what you have leftover, but increasing your cash flow just offers so many more opportunities. I haven’t really increased my living too much, so having that extra money to invest more is super helpful!
I love this – I did the same thing. It’s amazing how much you can do with even a couple of hundred dollars extra a month.
As a recent grad with student loans, I initially only invested enough to earn the full 401k match from my employer. As I gained confidence and talking with people almost ready to retire, I became focused on investing at least 10% of my income in my 20s so I don’t have to catch up as much later in life.
I especially love how you talked with people who were about to retire – what a great source of insight! It really doesn’t impact your paycheck tremendously, but I’m sure that extra 5% you put in will really help in the future.