The Priority: Paying off Credit Card Debt or Starting Investing

In my Pay Ourselves First post, I made the argument of starting investing right away even when one is paying a credit card debt with 18% interest rate:

While it makes a lot of sense to target the debt that charges some 18% interest rate first, I feel that investing should never be delayed even when one is deep in debt. For the long term, even $50 invested today will make a big difference 30 or 40 years later. So why don’t spare $50 and invest it while battling the debt?

That wasn’t the first time I made such claim and after the post was published, both Lazy Man of Lazy Man and Money and Jonathan of MyMoneyBlog expressed doubt whether it’s a valid statement. Though I firmly believe that in the long term, we will benefit from starting investing early, I never really compared the long term effect between the situation where investing begins after the debt is paid off and the case that paying debt and investing go parallel.

The assumptions

To prove my argument is either right or wrong, I sat down over the weekend and did some calculations myself. Here are my assumptions:

I have a credit card debt of $10,000 with an interest rate of 18% APR and I want to pay it off as soon as I can. In order to be debt-free, I can choose either to put all my savings of the month toward the debt and put off investing until the debt is gone, or allocate $100 for investing for my retirement and all the rest goes to debt payment. If I choose to invest, my money will earn a historical annual return of 1o%.

In order to do the comparison, I also create four different scenarios:

1. Make $1,000 debt payment every month without investing;
2. Make $900 debt payment every month and invest $100;
3. Make $500 debt payment every month without investing;
4. Make $400 debt payment every month and invest $100.

What I want to find out is: How much money will I have 30 and 40 years later with these strategies?

When to be debt-free

Now let’s see what I will be debt free with the above debt payment strategies. If I put $1,000 towards debt reduction every month, I can eliminate all my debt in 11 months (you can use Bankrate.com’s credit card debt calculator with inputs $10,000 debt, 18% interest rate, and $1,000 monthly payment to verify) with the change of balance at the beginning and end of the month shown in the following table.

For the $10,000 debt, I will pay a total of $10,916.22. For all above four scenarios, the next table summaries the length of debt period and total cost:

Clearly, the smaller the monthly payment, the longer the debt duration and the higher the overall cost.

The short and long term effect

The above table demonstrates that it pays to get out of debt as soon as possible. If the monthly payment is reduced by half from $1,000 (Case 1) to $500 (Case 3), not only the debt duration is more than doubled, the total payment is also higher by more than $1,000. Thus, in the short term, it makes a great deal of sense to concentrate on debt reduction and make it the top priority as, in this case, what one saved is what one earned. That’s guaranteed return, though not exactly at the 18% rate.

But what about the long term effect of pushing back investing? If my goal of saving and investing is my retirement, any delay now will be significant 30 or 40 years later. For instance, in Case 1, the investing won’t start until the 12th month when the entire debt is paid off. In Case 2, however, a small portion is allocated to investing from the very beginning. Even though Case 2 needs two extra months to be debt free and pays $106 more interests than Case 1, Case 2 will have an accumulated value of $317,404 after 30 years of investing $100 per month. Case 1, on the other hand, will have only $284,703. That’s a whopping $32,701 difference in value simply because of the 11 months delay! Even if the $106 saved interests are invested in the 12th month in Case 1, it only changes the total value to $287,682, still far less than Case 2.

Conclusions

I just want to use this example to show how important it is to start investing early, even for someone who is battling credit debt. If the only goal for people who are in debt is to be debt free, then all the efforts should be directed to debt reduction. In the short term, making monthly payment as big as possible can lead to big savings. If one also have a long term saving goal (such as retirement) in mind, it’s not a good idea to put off investing just because there’s a pile of debt need to be paid off. A consistent investing scheme, even a small amount every month (investing $50 a month will mean $158,703 30 years later), will make a huge difference in the long term. As long as we believe that the economy will continue to grow, despite once in a while short term downturn, investing should not be delayed.

Let compounding work its magic!