This is the first step in our complete series of Getting Started Investing. If you’re a beginner who’s looking to make your first investment and build wealth for the future, then read on.
Yes this site is about investing, but unfortunately having massive amount of debt is all too common in our society. So we must at least discuss debt, how it relates to investing, and tackle this common problem first.
Unlike Dave Ramsey or Suze Orman — I don’t necessarily think all debt is evil, or you don’t have the personal willpower to control your spending habits.
Debt can be used as a tool to increase income either immediately, like in rental real estate, or in the future like a college education.
A few rules of thumb for good debt:
- It’s a long term loan – 10 years or greater.
- You can use the debt as a hedge against inflation.
- You can invest for a higher return than the interest rate on your debt, it is considered good debt. Generally, mortgages and student loans meet this test, while credit cards usually do not.
- The interest rate is fixed, as opposed to adjustable, revolving or balloon payment. Adjustable, revolving or balloon rates amplify the risks associated with taking on the debt.
This doesn’t mean you should go into $200,000 of debt for a Sociology degree, or buy a 10,000 square foot house when only making $100,000 a year.
When debt is considered good debt, it’s only under the correct circumstances, at the right time, at certain terms. To learn more about good and bad debt, check out this article that breaks down the differences between the two, How to Tell Good Debt from Bad.
Good does not exist without evil. Eradicating bad debt is the best investment you can make — both in terms of the return and your restored sanity. As an added bonus, it is a low risk, guaranteed return investment.
So what is bad debt? Credit cards come to mind. Why? For one, they usually have inflated interest rates when compared to student loans and mortgages. They also usually represent hyper consumerism — not always, but often.
A simple rule of thumb — It makes sense to pay down debt first before investing, if the investment rate of return is lower than your debt APR.
Why You Should Pay Off Debt
It locks in a guaranteed rate of return! In this low interest rate environment, try finding a fixed income investment that returns at the rates you have on your credit card debt. Paying down a credit card with a 19% APR has no risk for return. An investment’s return, on the other hand, is never guaranteed.
It frees up your cash flow. What could you do with all the extra money lying around after you no longer have debt payments?
It removes risk. Debt of any kind comes with a certain amount of risk. How would you pay your bills (including your debt) if you lost your job? What about if you were disabled? Paying off your high-interest debt removes quite a bit of risk from your overall financial life.
It reduces stress. If you’ve ever laid in bed awake all night worrying about money, you know what I’m talking about. Debt, especially debt with high interest rates, is stressful. Get rid of it now, so you can get some sleep!
For more information on the benefits of paying off your high interest debt, check out this article on the subject, The Best Type of Investment: Paying Off High-Interest Rate Debt.
A Faster Method To Eliminate Debt
While you can continue to pay off traditional credit card debt, the issue for most is high interest rates. Rates as high as 21% is not uncommon. In some cases even higher! This is especially true after debt crisis where new government rules caused a spike in credit card rates. The problem is how can your credit card debt be paid off quicker?
This is where peer-to-peer lending (otherwise known as P2P) comes in. It might be a new to you, but it’s a great way to off your debt at a lower interest rate.
There’s a huge gap from the interest rates traditional credit cards charge, to what you can get at a P2P company.
Both allow for unsecured debt loans as high as $35,000, and possible rates lower than 7% APR. Of course rates depend upon your credit score, and the purpose of the loan. Loans from can be up to five years with Lending Club. Otherwise both offer three year loans.
Using one of these services will help speed up your debt payment and get you on the path to investing.
Of course this should go without saying — Don’t take on any new consumer debt!
The Importance of Paying Off Debt BEFORE Retirement
Getting ready to retire? You worked hard your entire life, you scrimped and saved to retire with dignity, and you are ready to get some well deserved R&R. Before you take the plunge, make sure that debt is paid off!
It’s simple! The less money you are paying towards debt, the more money you can invest for retirement. Less money going out now = more money coming in then.
You will have lower expenses. Do you really want to have a lot of extra bills in retirement? Get rid of debt so you can spend your extra cash enjoying your golden years.
Eliminate one of the X factors. Debt brings with it a certain amount of uncertainty. Eradicate it so you can be prepared when other X factors enter your life — like adult children moving back in or health issues.
Have more control over your assets. Anything you owe money on does not really belong to you…yet. Pay off your debt for the peace of mind that your assets are in fact yours.
Holding onto debt will definitely cramp your retirement style. Read The One Thing You Need To Do Before Retiring for more information on the benefits of a debt-free retirement.
Do you know how much you spent on food last year? What about clothing, electronics, or entertainment? If the answer is no, you’ve got some work to do! It makes sense to track your budget using a tool like YNAB (You Need A Budget).
If you don’t know your outflows, how can you know how much income you need for retirement?
You should know HOW MUCH money you are spending. Most people are very aware of how much they are saving and giving away, but spending slips through the cracks.
By knowing how much spend and what you spend it on, you will be able to make tweaks and changes to adjust that spending to align with your financial priorities — like getting out of debt.
Assess Your Financial Habits
On a more obvious note, you should never be spending more than you make.
Make sure your spending habits are allowing you to pay off debt, and not putting you further in the hole. Check out How to Maximize the Return of All Your Financial Activities to read more about spending and saving efficiently.
By leveraging debt as a tool, it can quickly turn from foe to friend. For example, it is often a good idea to keep your mortgage around as opposed to prepaying it. A few things to consider when deciding whether or not you want to pay off your home early:
- How many years do I plan on living here (or keeping this rental property)?
- What are the terms and interest rate?
- Can I refinance for a lower interest rate?
- How high are my federal and state taxes?
- Do I have other high-interest debt that I could pay off first?
There are many reasons people choose to pay off their mortgages early. However, there are also reasons to keep it around for the life of the loan (or close to it).
- The mortgage tax deduction — note: this is only relevant if you itemize on a schedule A.
- Inflation can work in your favor, as goods get more and more expensive each year.
- Opportunity costs should also be a factor. When mortgage interest rates are low, it is often more beneficial to invest in other assets with a higher rate of return.
In the end, this decision has to be made based on your individual situation. For more information on why it might not be a great idea to prepay your mortgage, read the article: You’re A Fool To Prepay Your Mortgage.