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The No Brainer: Pay Off Debt or Invest?

Todays Date: November 20, 2018

Although it may seem confusing at first glance, it should come as no surprise why financial advisors encourage you to start savings when you have a pile of debt. Why do they advise this way? Because financial advisors are commissioned salespeople. If they do not sell you their product (investments) they do not get paid.

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.

To better appreciate the severity of her situation, let’s assume that her financial advisors encourages her to invest $250 per month. This further reduces her already diluted after-tax dollars to less than $1,500. While she started out with $2,000, she now has 25% to enjoy her lifestyle.

Now, if this individual had no debt at all, the $250 might make perfect sense as she is already spending more than that on her debt payments. So, what impact does paying debt and investing have on her long-term savings? Of course, there is no easy answer because there are two things we need to consider.

Our first consideration will be whether this individual can afford the $250 that the advisor recommends. In the event that she can, she should actually take the $250 and bulk up her credit repayment plan (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). Doing so will reduce her repayment schedule from 57 months to less than 35 months. In other words, she will be debt free in less than 3 years, at which time she can realistically invest both the “affordable” $250 that the advisor suggested and the $267.14 that she will no longer have to repay toward her debt, for a total monthly investment of $517.14

The other factor to consider is timing. If she has only 15 years left to invest, what happens if she postpones her start date by 3 years while she repays debt? The impact is negligible, in fact. By repaying all of her debt first, she might only be left with 12 years, but she will be able to invest more once the debt is repaid ($250 + 267.14 instead of just $250 today). This translates into additional, compounded savings of $38,283, assuming a constant rate of return and that she can still invest $250 + 267.14. Not only does she come out ahead to the tune of thirty-eight thousand dollars, but she is debt-free, allowing her to weather unforeseen financial turbulence in the years to come.

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).

As evidenced above, accelerating a debt repayment plan should often take priority over investing for the simple sake of future compounded growth. This statement contradicts a lot of what has been written already about wealth building, but the illustration above shows us just one way a debt-free lifestyle allows us to enjoy greater wealth down the road. Of course, there are some rare instances where an investment plan should be used in conjunction with a debt repayment schedule but, again, those situations are rare.

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