One of the biggest decisions you’re going to face when beginning to invest is whether or not to pay off debt first. The answer is debatable, and obviously, it varies on the type of debt and investment. I have been struggling to understand which one I should do first. After going through a few case studies, I would like to share my two cents and hoping to increase my financial knowledge. The key underlying factor that I should focus on is the interest associated with each debt and potential gain from an investment.
For example, Johny has a car loan of $10,000 at 5 percent interest for five years. He will pay $12,762 over that time. If he has an opportunity to invest at a 7.5 percent dividend per year instead, he will end up with $14,356. A positive 2.5% difference or an additional $1,594 in his bank balance can now use to buy new clothes, gadgets, or maybe treat his parents to dinner.
The concept is easy to digest; however, the reality is not always rainbows and butterflies. The interest rate varies on each type of debt. Many of us and I am guilty of this, don’t even read the interest charges on late credit card payment debts. The consequences of not paying your credit card bills in full are enormous and can lead to bankruptcy for those who are not disciplined enough. It is fun to receive your first credit card, but without proper care, you may break your bank to pay the interest charges. Why? Because interest rates on credit cards are one of the highest amongst other debts. Why? Because credit cards are unsecured loans. Unlike a mortgage or a car loan where the bank has collateral to take if the borrower doesn’t make their loan payments, there is nothing the bank or card issuer can collect from you if you’re late on a bill, hence the high-interest charges. That small card you carry in your wallet every day gives you a loan without any security that you will pay it back. So how can I avoid the high-interest charges? Always pay off my credit card balance in full each month.
Now that I know my debt interest charges, let’s move on to the investment opportunities available. Can I get a 10% interest on checking account and 15% interest on a savings account? If I can, I am sure I will be by the beach drinking coconut water waiting for the sunset. The reality is, it is challenging to earn a higher return on investments than the interest charges on debt. Why? There are many unknowns with investing, and I must take into account risks such as market volatility, a global economic crisis such as COVID-19, and trade wars, to accurately compare potential benefits. These days, even fixed deposits are not yielding good returns. Those making good returns are in either equity or property market. Each market requires a deep and thorough understanding before one can quantify the probability of returns. Financial education is essential to evaluate the available investment opportunities such as fixed deposits, individual stocks, or even mutual funds. Some funds are capital guaranteed with good dividend payout annually.
Strategically, I believe that one should set a goal to both invest and pay off the debt at the same time. One should set the goal to minimize interest charges and maximize investment returns for optimum net balances.
So, going back to my question. Which one should I do first?
If I can earn a higher return on my investments than the interest on my debt, I should invest. On the other hand, if I am carrying high-interest debt such as credit card debt, it may make more sense to pay off my debt balance.
I am not a financial advisor, and I blame poor financial literacy in the existing education system. Many young people lack financial literacy and money-management skills, indicating an urgent need for educational programs to help them enter adulthood better equipped to handle their financial affairs.