At Aurora Financial Strategies we come across a lot of great questions. Below is one that I have come across a number of times:
"I want to start investing, but should I pay off my student loans or credit card debt first?"
Let me start out by saying that every reader's financial situation is different, and you should always consult with your financial adviser on what best suites your own goals. Ok, disclosures out of the way, let's dive in!
If you carry debt, specifically credit card or student loan debt, you are not alone. "The average credit card debt per household in the U.S. is $7,597 as of the 1st quarter of 2016" (via cardhub). Credit cards are one of the worst types of debt to carry, so coming up with an effective plan to reduce those balances is very important. To fully answer the "Invest vs. Make a Loan Payment" question we must first take a look at what type of debt we are working with.
Importance of Investing:
Let's be honest, the earlier you start saving, the better. Not only will you have more flexibility in the future, but you also get to experience what is known as "compound interest" for a longer period of time. Compound interest simply means that the longer you are invested, the more time your money can work for you in earning returns; as illustrated by this graph:
Even if you double your initial savings at age 40, you still never catch up to the level savings amount from age 25. The earlier you begin your investment, the longer period of time "compound interest" can work for you!
401(k)s or 403(b)s
Are you currently contributing to your company's 401(k)? Does your employer match your contributions? Is available, always invest at least up to the maximum that your employer will match, this will ensure that you are maximizing the benefits available to you through your employer. I generally like to say it this way:
"I Like to Think That We are Pretty Good at What We Do, We Can't Come Close to Competing with at 100% Rate of Return That You Would Receive From an Employer 401k Match"
Before considering making additional payments to debt, I would consider contributing up to your employer's match in your current retirement plan.
IRAs, Roth IRAs, or Investment Accounts
We've discussed if a Traditional or Roth IRA is a good solutions for your situation. This is where we really need to take a look at the type of debt you would hold when investing. Historical stock market returns over the past 100 years have typically averaged between an 8-11% rate of return. Keep in mind, this is an average. There will be times when returns are significantly higher than the average, but also periods of poor performance as well, but in general if you stay invested for the long-term you can expect a reasonable rate of return. The calculation for your debt vs. invest decision is really fairly simple:
"If you are paying more in interest on your debt than you are earning in your investments, it probably makes more sense to accelerate the debt payment."
What to Do with Each Type of Debt:
Home Mortgage, Vehicle Loans
Typically, when you finance a home or vehicle, your interest rate will be fairly low. The reason for this, is if you happen to default on your payment, the home or car can be used as collateral. These loans, especially for homes, typically tend to be for a longer term as well, as long as 30 years. On top of that, if you itemize on your taxes, you can typically write off the interest paid on your mortgage or home-equity line. For that reason, we typically say:
"With rates at historical lows today, over the duration of your mortgage you typically have a higher chance earning a larger return by investing with a professional."
Credit Card Debt
Credit card debt typically carries a higher interest rate on your monthly payments because it is not backed by the value of any of your assets. As we mentioned above, credit card debt is common for households in the U.S., but if you carry too much, you should work with a professional adviser to come up with a plan of attack to reduce this debt. On top of the higher interest rate that comes with credit cards, the interest is also not deductible for tax purposes. That is why we normally say:
Credit Card Interest Rate: 14-29% > Stock Market Returns: 8-11%. Pay those cards off First!
Student Loan Debt
Now that we have an answer for when to invest while carrying a mortgage or credit card debt, figuring out where to order Student Loans is a little bit of a different animal. As we mentioned above, historical market returns indicate that you will generally average between 8-11% invested in the market, and most student loans range in the 5.00%-8.50%. Assuming your income is under certain limits, you may also be able to deduct student loan interest paid. That being said:
"If you are generally aggressive in nature, investing in the market does make sense, if you see yourself as more conservative or really enjoy the idea of not having a looming debt above your head, you might be more interested in paying off the student loan debt first"
3 Other Items to Consider Before Saving in the Market
Building an Emergency Fund - If something happens to you short-term, or you have a major unforeseen expense, your emergency fund would be available for you to use without dipping in to your investments or racking up a large debt
Do You Have Enough Life Insurance to Cover Survivor Needs for Your Loved Ones - If you get hit by a bus tomorrow, are the members of your family that are counting on you taken care of? If so, it makes sense to invest in the market. If not, speak to your financial adviser today.
Figuring Out What You Need to Save in Order to Achieve Your Goals - I'll let Warren explain this one (see below)
As always, if you have a question of your own, feel free to reach out to me at firstname.lastname@example.org
Bill Cardwell CFP®
Bill Cardwell is the founder and President of Aurora Financial Strategies, a financial advisor practice based out of Kokomo, Indiana. He can be reached at email@example.com or by calling (765)438-4682. Advisory Services are offered through Creative Financial Designs, Inc., A Registered Investment Advisor, and Securities are offered through cfd Investments, Inc, a Registered Broker/Dealer, Member FINRA & SIPC. Aurora Financial Strategies is not Owned or Operated by the CFD companies