The decision to begin investing while you still have debt hanging over your head isn’t a black or white proposition. A lot depends on what type of investments you’d like to make and what type of debt remains on your personal books. Is it high interest debt, low interest debt, or tax deductible debt?
If you are in debt but you want to begin investing anyway, it’s best to seek out investments with a greater return than you incur from your debt. For example, if you have a car loan at 7%, you’ll generally want to find an investment vehicle that returns greater than 7%. Otherwise, investing while you’re in debt can feel like taking taking two steps forward and three steps backward.
What type of debt plagues you?
- High interest debt
- Low interest debt
- Tax-deductible debt
High interest debt
The term “high interest” is relative, but I would consider anything higher than 12 percent to be “high.” The primary contributor to your high interest debt is your credit card. If you’re carrying ANY balance on a high interest credit card, paying it down should be a much higher priority than investing. Consider moving any high interest debt to a zero percent balance transfer card found on my Credit Cards page because finding an investment that will return a greater rate than your credit card is next to impossible.
Low interest debt
This type of debt may stem from a car loan, a line of credit, or a personal loan from your bank or credit union. This type of debt is generally “prime plus” meaning that the interest rate adds a set amount to the prevailing prime rate. While it’s easier to overcome debt at 12% than at 24%, it is still difficult in today’s market. Difficult, but not impossible.
Tax deductible debt
If there IS a “good” debt, I would classify tax deductible debt that way. Tax deductible debt could include mortgages, student loans, business loans, or any other loan where the sting of the interest is lessened by the ointment of tax deductions. Since tax deductible debt is usually low interest as well, it’s much easier to build your investment portfolio while paying it down.
If you have low interest debt and/or tax deductible debt, continue reading but if you’re saddled with high interest debt – STOP. Pay it off first. After you’ve built an emergency fund, focus your energies and resources on paying off your high interest debt. Investing can come later.
Why invest while you’re in debt?
When you’re working to pay off any type of debt, you’re robbed of the capital – not just in money lost, but of compounding time lost. For any investment to pay off, the key is TIME. You need to give your money as much time as possible to compound and grow. That’s why it could be important to start investing now. Your investment amounts may be small, but with the added component of time, they will have the chance to grow to larger amounts than the greater amounts you invest later in life. Small amounts invested sooner generally outperform larger amounts invested later.
An investment plan while in debt
- Funds available to invest AND put towards debt reduction: $1,000
- Debt payments (low interest and tax deductible debt only): $800
- Available for investment: $200
A typical portfolio has a range of investments, some low risk, some moderate risk, and a few high risk. While you’re in debt, you could consider the amounts you’re putting toward debt reduction your low or moderate risk investments. The majority of your “returns” will be in debt reduction and lower interest paid out rather than in the 3% to 6% you could get from bonds or other low risk investments. The balance of your available funds can then be invested in higher risk, higher return equities and investments. If you are a very low risk investor, then the majority of your investing activities will be focused on debt reduction with just a minimal amount going toward higher risk securities.
Even those of us with a higher risk tolerance may have to spend more than we like on debt reduction and force us to use a more conservative approach. In my example above, a high risk tolerance investor would put the $200 into stocks while a low risk tolerance investor might put only $100 into stocks and $100 into bonds.
You CAN invest while in debt
Paying down debt can be monotonous, boring, and even demoralizing. We tend to think: I need to pay off this debt so that I can live a normal financial life – saving, investing, and enjoying the benefits of having money. Debt puts our lives on hold. But by having even a small portfolio that we fund on a regular basis, we can escape the dreariness of debt elimination.
As long as you’re not paying on high interest debt, I believe you should contribute to an investment portfolio. If you want to grow your money, it’s critical to begin investing as soon as possible.