If you have extra cash or come into a sudden windfall, is it smarter to pay off your debts or invest the money?
A woman came in to my office the other day wondering this exact thing. Well, she didn’t ask the actual question… I did.
She had a mound of credit card debt, clicking away at 12% interest. What surprised me, though, was that she already had the $50,000 needed to clear out the credit card debt. Interestingly enough, she didn’t plan on using any of it to pay off the card! She wanted to invest the money instead. She estimated that she could earn much more than the 12% she was paying on the credit card, so she concluded that paying it off was a silly thing to do. Her money was best served elsewhere.
It turns out that this woman was in debt all over town, even though she had substantial assets. Never mind that her credit score was in the dumpster, she wanted to invest. I had to convince her to reconsider.
Could She Have Been Right?
To you and me, the answer in the above woman’s case might be a no-brainer. But other situations aren’t so clear cut. In order to really address this issue, you have to understand all the components of the question.
First, there is the basic financial question, which is rather simple. Ask yourself which number is greater, the return on your investment or the interest you are paying. If you are paying more interest than you could earn, you are far better off by paying down the debt.
For example: assume you owe $10,000 on a credit card. Let’s say that you actually have the $10,000 in the bank, which you could use today to get out of debt completely. The credit card interest rate is 10% and the bank is paying you 1%. At first, this seems like a slam dunk. Pay off the credit card. Right? Not so fast…
Assume that you also have an opportunity to invest $10,000 in your brother’s “can’t lose” vending machine business. He tells you that investments are earning 30%, which is quite a bit more than the 10% you’d save paying off the credit card. Now, the choice becomes more complicated.
If you pay off the credit card, you are making a guaranteed 10% return. Why? Because that’s money that you’ll keep in your pocket rather than sending it off to Visa or Mastercard.
If you invest in the vending machine business, you are guaranteed nothing. You might earn 30%… or even more! But you could also lose everything. It’s happened once or twice in the past when people invest in small businesses.
So, which is greater? A guaranteed…