When it comes to investments, people naturally chase the highest possible returns on their money, and that makes sense. But one of your best investments can be paying off high-interest rate debt. Not only is this a simple and low-risk way to allocate your money, but the investment “return” can be higher than anything you can get in a stable investment vehicle.
If you’re earning an average of 10% per year in your stock portfolio, but paying 12% per year in interest on your credit cards, you are losing money — even though you seem to be making a higher return on your stock positions.
Worse yet, if your stock returns go to zero, or go negative, the interest you’re paying on your debts will not go away, and the exchange will become even more unfavorable.
As an investor, one of your goals should be shifting from being a borrower who pays interest to others, to a lender who collects interest from others. When you do, money is always flowing to you, rather than away flowing away you.
Below are some practical reasons why you want to payoff high interest rate debt.
Lock in a Guaranteed Rate of Return
Any time you pay off high-interest debt, you’re effectively locking in a high-rate of return on your money. Let’s say you have $10,000 in credit card debt, with an average interest rate of 10%.
By paying the debt off, you lock in a 10% rate of return on your money. Best of all, the rate of return is guaranteed, and there’s no investment anywhere right now, that will guarantee you a risk-free 10% return.
Still another issue with paying high interest rates is the compound interest factor. Compound interest can be either your friend or your enemy, and it’s fundamental that you make it your friend.
When you are in debt, and especially when it comes at a high rate of interest — say, anything greater than 5% — then compound interest is your enemy. It slowly drains your financial resources and transfers them to someone else. But when you’re debt free, and lending to others, you shift the compound interest dynamic in your favor.
Free Up Cash Flow
Any time you payoff a debt, particularly a high-interest rate debt, you’re not only improving your balance sheet, but also freeing up your cash flow.
In general, debt payments reduce your cash flow, and thus your income. If you earn $5,000 per month, and have a debt payment of $500, your income has been reduced to $4,500.
Worse, most debt today carries no tax benefit. Unlike a mortgage, a typical debt will not be partially offset by a reduction in your income taxes. You’ll be on the hook for the entire payment.
Paying off a debt is like giving yourself a raise in pay. You will suddenly have more money — either to enjoy life more or to put into investments to earn more money. That will give you more control, to do what you want with your money, and use it to improve your life.
Remove Risk From Your Life
Debt — even high-interest rate debt — has become so common, that we often fail to recognize the risk we’re exposing ourselves to. A loss of a job or business can make it hard or even impossible to service a debt. You may have to liquidate savings and investments to pay your debts, and if you can’t, there will be a set of consequences.
If you can’t make your car payment, your car will be repossessed, which will impair your ability to get a new job and make a living. Failure to pay credit cards can lead to collections and judgments. Either situation can result in the destruction of your credit, which will carry negative consequences for years to come.
Those are just some of the risks that debt adds to your life — risks we don’t think about too much when everything is going well. But any debt you can payoff will reduce the overall financial risk you’re carrying in life.
If you are taking significant risks with your investment portfolio, eliminating debt will be an important form of diversification. Since it will reduce your overall risk level, you will have greater freedom to take risks in your investments.
Reduce Stress So You Sleep Better
Since debt is a form of risk, it also creates uncertainty and stress. In fact, so much of the financial uncertainty we all face is closely associated with how much money we owe.
Variable rate debt, such as credit cards or even home equity lines of credit, are particular sources of uncertainty. Not only is there potential for interest rates on these debts to rise, but it’s often likely to happen at the worst possible time — such as when the economy is heading into a recession.
Uncertainty can cause stress in life, and that can compromise your ability to do your job effectively, to enjoy your life, and even to get a good night’s sleep.
If you payoff your debts, or at least the high and variable-rate variety, you’ll be removing a large measure of uncertainty from your life. This will reduce the stress and you live with, and help you to be more confident, and effective, with your life in general.
Have you applied paying off consumer debt into your investment strategy?