The topic of paying off debt vs investing came up at work the other day, and I was a little surprised by some of the ideas that were floating around. A friend mentioned wanting to get into investing, “playing the markets” as he put it, and his desire to set some money aside for retirement. He still has quite a bit of student loan and credit card debt though, and was wondering if it was smarter to pay those off first. The answer should be yes, pay down your debt first before investing, and a lot of this has to do with interest and where your money would be best spent.
Suppose you have $5000 to invest. You could buy some shares of AAPL (the hot, huge growth stock everyone seems to be investing in today) hoping to capture some very attractive gains. And you very likely could. But what if something happens to that stock and you don’t get the growth you were expecting?
Investing is almost like a form of gambling in a way, in that there are no (or very, VERY few) guarantees. High reward is all too often accompanied by high risk. You could do well, or you could lose. On the other hand, with debt one thing is certain – interest growing on it will be your constant companion for as long as you have it. I’d rather deal with the very real certainty of debt increasing through interest than the potential of market gains, especially in today’s climate.
I was met with two different objections to paying down debt before investing: First, he cited reports saying that starting your retirement savings as early as possible can make a huge different in your total portfolio value by the time you retire. He was talking about compounding growth, which is a very valid point. The second had to do with the psychological component – it’s easier to stick to a plan when you like what you are doing and can see the progress being made. Saving and investing for retirement is more fun than paying off debt. You get to see your portfolio grow, knowing you’ll get to enjoy it in the future, as opposed to paying down debt with money you’ll never see again (regardless of the fact that you spent it in the first place.)
So what should you do? The short answer is pay down your debt first. Again I’ll say, market gains are not certain whereas interest accruing on your debt is. For example, let’s say you have $5000 on a bank credit card charging 15%. That $5000 you invest hoping to get 10% growth for the year is worth less to you than the 15% interest you owe on your credit card debt. It’s the equivalent of paying $115 to buy $110 – a deal no rational person would make. That $5000 would have been better spent paying down your debt first. Sure, there’s a chance you could make more than 15% if your investments did exceptionally well. But again, it’s a chance and not a guarantee. That 15% interest will get added to what you owe every single year you still owe it without fail. So why take the risk that your market gains could outpace it?
Another serious point that many people forget is that most investments (especially in an RRSP) cannot be liquidated into cash quickly and therefore shouldn’t be relied upon for emergency use. What happens if you lose your job in 6 months? It’s easy to stop contributing to an RRSP in that case, but can you stop paying on your debt? Concentrating on paying down your debt now and building a decent cash emergency fund would serve you much better than holding some really great investments locked away where you can’t get them.
I’ll freely admit there is a lot of grey here and it’s not always as cut and dry as that. Obviously everyone’s circumstances are different and in reality some form of balance can be struck. And of course, it’s ultimately up to you, what you’re comfortable with and how you choose to manage your money. Perhaps concentrating on debt repayment while still investing a small amount each month can help scratch the investing itch while still being smart. One plan to get you excited is to do the math on what you pay on debt each month, then imagine having all that extra to invest with once it’s paid off. That’s some pretty powerful incentive to reduce or better yet eliminate debt before investing too heavily.
As a final note, I’m speaking mostly of “bad consumer debt” here, not “good debt”. Things like credit cards and high interest loans can have some seriously high interest rates and are considered bad debt to carry over long periods. Mortgages on the other hand can be thought of as good debt, as rates (especially in recent years) are comparatively low and you’re building equity in your home as your pay it down, which can be used later.