Invest or Pay Off Debt, It's a No Brainer

By: Chris Blanchet

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.
Okay, the power of compounding is certainly a valid argument that advisors will make. However, this argument is invalidated if you carry $22,100 in debt like the average American and your income hovers around the median. In other words, a few bucks in credit payments is different than struggling with payments and investing at the same time.
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.
Consider the following scenario. Where an individual earns $2,000 in after-tax income but just $22,100 in debt at an average rate of 14.5%, her cash dilution rate is a startling 13.35%. What this means is that the debtor keeps only $1,732.86.
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.
If this individual actually had no debt, then the $250 in investments would work perfectly because she is already paying more than that every month on her credit repayment. What impact will repaying debt and investing at the same time have on her long-term savings? That will depend on two things.
The first thing to consider is whether this individual can indeed afford to invest $250 per month. Assuming she can, then she should really refocus this money toward debt repayment (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). By using this extra $250 to repay debt, she will reduce her repayment schedule from 57 months to a little less than 25 months. That means that in 3 years, she invest both the $250 that the advisor recommends and the $267.14 that she is already paying toward debt, for a total of $517.14 per month.
Another factor weigh is timing. If our investor has only 15 years left, as of today, that means she loses 3 years of potential compounding. The impact will this have on her savings is minimal. By deferring her $250/month savings and repaying debt instead and then, in three years investing $517.14 per month instead, this individual will have saved $38,283 more over 12 years (remember, she lost 3 years by repaying that debt first) assuming the rate of return is constant and she can still invest $250 plus the $267.14 she saves in credit repayments. More importantly, after 3 years, she will be debt-free, which automatically puts her in a better position to tackle unplanned financial hardships.
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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Chris Blanchet has over fifteen years of experience as a Financial Advisor. He is the author of the Personal Finances e-Book Help Fix My Finances, which is the basis of the Members Only website the same name. Be sure to visit his Debt Free Blog.

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