Investing In Debt - Try Credit Fix

It should not come as a surprise why financial advisors will tell you to start investing now, even though they all agree behind closed doors that eliminating debt should be a financial priority. The reason they do this? They have families to feed, too; if they don't sell their product (investments) they don't eat.

Many advisors will emphasize that the power of compounding outweighs paying a few bucks in interest every month. Which is true; but a few bucks in interest is unlikely for most of us (the average American carries $22,100 in debt). As a result, investing early and making credit payments will hinder your lifestyle and keep you in debt.

We can put this argument to the test by knowing your Cash Dilution Rate. What this rate reveals is exactly how much we give away to the people we owe money to. For example, if we earn $100 after-tax and have a dilution rate of 16%, we enjoy only $84 of this money. The higher our rate, the more it makes sense to forego investing right now in favor of repaying our debt.

Consider the following scenario. Where an individual earns $2,000 in after-tax income but just $22,100 in debt at an average rate of 14.5%, her cash dilution rate is a startling 13.35%. What this means is that the debtor keeps only $1,732.86.

One way to understand the severity of this situation is to weigh the $267.14 in monthly credit costs against how much can be invested on a monthly basis. For example, investing an additional $250 per month reduced the amount this individual keeps every month even further to less than $1,500 ($2,000 - ($267.14 + 250.00)).

However, if this individual could eliminate all of her debt, the $267.14 in monthly savings could be earmarked for her investments. What damage does this cause to her long-term savings? That depends because there are two ways to tackle this scenario.

In the first case, this investor might find that an additional $250 per month to invest is, in fact, not much of a sacrifice. If this is the case, then that additional $250 should still go toward repaying debt (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). This would reduce the debt even faster, from a little more than 57 months until full repayment without using the extra $250, to a little less than 35 months if she uses that $250 to repay the debt. Once all of the debt is repaid, the $250 + $267.14 can be invested for a total investment value of $517.14 per month.

The other factor to consider is timing. If she has only 15 years left to invest, what happens if she postpones her start date by 3 years while she repays debt? The impact is negligible, in fact. By repaying all of her debt first, she might only be left with 12 years, but she will be able to invest more once the debt is repaid ($250 + 267.14 instead of just $250 today). This translates into additional, compounded savings of $38,283, assuming a constant rate of return and that she can still invest $250 + 267.14. Not only does she come out ahead to the tune of thirty-eight thousand dollars, but she is debt-free, allowing her to weather unforeseen financial turbulence in the years to come.

Another way to look at this is to assume that after nearly three years of paying $517.14, she wants to start enjoying more of her life and decides that instead of investing $267.14 (what she saves in credit payments) plus the full $250, she invests only one half of the $250 and spends the other $125 on something frivolous (like shoes). Spending $125 on shoes allows just $392.14 to be invested. Taking into account that she starts investing three years later, she would still come out farther ahead than if she invested $250 per month today (she would be ahead to the tune of $7,167, it turns out).

As evidenced above, accelerating a debt repayment plan should often take priority over investing for the simple sake of future compounded growth. This statement contradicts a lot of what has been written already about wealth building, but the illustration above shows us just one way a debt-free lifestyle allows us to enjoy greater wealth down the road. Of course, there are some rare instances where an investment plan should be used in conjunction with a debt repayment schedule but, again, those situations are rare.

Investing or Pay Off Debt, It's a No Brainer