The Priority: Paying off Credit Card Debt or Starting Investing
By Sun
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 donâ€™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:
- Make $1,000 debt payment every month without investing;
- Make $900 debt payment every month and invest $100;
- Make $500 debt payment every month without investing;
- 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.
Month | Beginning balance |
Ending balance |
Monthly payment |
1 | $10000 | $10150 | $1000 |
2 | $9150 | $9287.25 | $1000 |
3 | $8287.25 | $8411.55 | $1000 |
4 | $7411.55 | $7522.73 | $1000 |
5 | $6522.73 | $6620.57 | $1000 |
6 | $5620.57 | $5704.88 | $1000 |
7 | $4704.88 | $4775.45 | $1000 |
8 | $3775.45 | $3832.08 | $1000 |
9 | $2832.08 | $2874.56 | $1000 |
10 | $1874.56 | $1902.686 | $1000 |
11 | $902.68 | $916.22 | $916.22 |
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:
Case 1 | Case 2 | Case 3 | Case 4 | |
Debt duration | 11 months | 13 months | 24 months | 32 months |
Total cost | $10,916.23 | $11,022.38 | $11,978.27 | $12,627.9s |
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!
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I’m sorry to say your math is wrong. If paying less toward debt and investing more yields more in the long run, why invest only $100? How about paying minimum balance and investing the rest? Borrowing at 18% and investing at 10% is not going to make anyone rich, except the lender.
In your specific scenario, at month 13, case 1 (invest after debt payoff) will have $2,093.51 in investment balance, because after the debt is paid off, $1,000 goes toward investment ($83.77, $1,000, and $1,000 in month 11, 12 and 13). Case 2 (invest $100 while paying off debt) will have $2,044.65 at month 13 ($100 a month invested for 12 months plus $777.62 in month 13 after payoff). After month 13, everything becomes the same. Because case 1 has more in investment at month 13, it will have more in the end. The difference looks small because the payoff period is short. If the payoff period is 3 years vs 1 year, the difference will be quite large.
Could you post accumulated values of investing for Cases 3 and 4 after 30 years of investing?
I still think you are looking at this the wrong way. The debt payoff and the investing are both means to a goal– growing your wealth. And the debt payoff leads to more total wealth in the end.
Consider your two scenarios, but a more fair comparison is that you have $1000 each month to put towards either– and when debt repayment is over, the full $1k goes to investing. In scenario 1, you begin investing a partial investment in month 11 of your debt payoff, then invest $1k per month thereafter. Your total wealth after 30 years is $1,882,301.06. In scenario 2, you invest $100 each month and pay off $900 until the debt is paid off, then invest all of it. Your total balance after 30 years? $1,880,074.98. These calculations were done in Excel.
You do better (though only marginally) by paying off your debt. Why? Because the $100 works harder for you (@ 18%) in the debt repayment than it does in the investing (@ 10%). Overall it gives you more dollars to put in your investment account, and the small delay in initial investments does not overcome this difference.
Another thing to consider: your money is working on growing your wealth either way– one of them is via an 18% guaranteed return through debt reduction, and the other is a potential 10% return through investing. The choice is pretty clear even if the 10% were guaranteed (which it isn’t). $100 per month working at 18% goes a bit further than $100 at 10%.
/agree with the above posters. Even without getting into the details… you have either:
1) 18% on $x over y years working AGAINST you; or
2) 10% on $x over y years working FOR you.
How can (1) ever be better for you than (2)? Unless of course, you’re into the whole self-inflicting thing.
The biggest problem you ignore is where did the $10,000, 18% debt come from? If a person never learns to control spending to less than they bring in they will never have anything left to invest in the first place.
Even if the rates were similar I’d still tell the person to pay the debt as quickly as possible. Otherwise they’ll just be borrowing against the investment in a couple years.
Thanks for the comments!
What I want to say with this post is that investing should not be delayed even when in debt and the effect of starting early, thus having a longer accumulation period, could be significant. It’s NOT about arguing that invest the money and get 10% return is better than paying off credit card debt with 18% interest rate. That’s not my intention. Otherwise, I could have suggested $900 in investing and $100 in debt payment, instead of the opposite. The assumption is that one is determined to get out of debt thus making $1,000 or $900 debt payment rather than just paying the minimum.
My example is more like the case that one has only $100 to invest, instead of $1,000. In Case 1, the person decides to use all the money to make debt payment and only start investing when the debt is paid off, though the investment could be as little as $100 a month. In Case 2, investing starts from the very beginning and, at the same time, the majority of the money, $900, is used for debt payment. Though for Case 2, the debt duration increases, the investments of $100 a month when in debt make it’s impossible for Case 1 to catch up. This may not be an ideal example, but it could happen in reality when someone uses the debt situation as an excuse of not to invest and when they finally debt free, they may not necessarily put more money into investments.
TFB & Brad: Your example is also a fair example that represents another case. Of course, in my example, the difference in debt length between Case 1 & 2 is very small (only two months). If only $500 or $400 a month is for debt payment as for Case 3 & 4, Case 1 will no doubt be the winner.
Brad nailed it.
hey mr sun, found your article while search for “debt-payment vs investing”. say in my situation, i have $10,000 @ 3.9% for life (sometimes you just have to call them up) in credit card debt. how much of $1,000 would you put toward debt payment (on top of minimum payment) vs investing each month?
There is no accounting for risk mentioned here. If you have outstanding debt, and you begin to invest, you are essentially borrowing money at a high interest rate in order to invest it.
You can’t fill in a hole and build a mound at the same time.
Borrow money, speculate and make profit, then pay back the borrowed money. That’s what a stock broker do. 4% is not exactly high, Perkins student loans runs at fixed 5%.
If you let me borrow from you at 1%, I’ll be glad to do so!
Sun,
I’d urge you to check your math. You seem to be using a 10% annualized yield as if it were a monthly compounding interest rate. That’s actually a total return over the year including compounding on a monthly basis.
Therefore if you calculate that the very first $100 will earn 10% per year for 13 months you’ll get $100*13*(0.10/12) or $10.83 interest. Do the same throughout and you’ll see that the total interest earned on that $100 per month is $75.83 whereas your debt just cost you $106.15.
Now you argue that the magic of compounding fixes this – because you got your money in early.
Brad and TFB are 100% correct. Your whopping difference comes from changing from $1000 in financial transactions to $100 as soon as debt is paid off. Therefore case 1 only saves $200 in months 1-13 while case 2 saves up $1375 from deposits plus interest. What did the case 1 do with the extra $900 he/she had for months 12 and 13?
Now – tell me who’s going to have more money in the end of 13 months of $1000 per month going into debt or investing. Is it the guy depositing $100/month who has $1375 at the end to compound over 29 years or the guy that has $2000 to compound over 29 years?
It’s very alluring to tell people that they should be investing while in debt because it makes them feel better. Perhaps a finance text book would be a better place to start…
deemzzz is right. You’re changing the rules at the end of the debt payoff. To do it your way and correctly, you have to assume that you have a debt reduction budget of $1000/month and an investing budget of $100/month. So each month you’re putting 1000 towards the debt until it’s gone and then you keep putting the 100 towards investing. You’ll find that if you put the whole 1100 towards the debt and then when the debt is gone you start making 100 contributions to the investing you’ll get a different result. But you can’t change the rules halfway through which is what you’re doing by changing the amount you contribute in total at some future point.
Interesting math from everyone. I would have to say that it’s more fulfilling for me to say “wow, I’m finally credit card debt free” in a lot less time. That’s just me, though.
deemzzzz: The way I calculate compounded return is as follows. If I invest $100 when the year begins and earn annualized return of 10%. Then at the end of the year, I will have $110. Now since I invest monthly instead of annually, I will break that 10% annual return into monthly returns and compound the interest every month instead of once a year. To get the same $10 return at the end of the year, the monthly rate will be x% (I don’t have the exact number now). For a 12-month period, if compounding monthly, the total value at the end of year will be 100*(1+x%)^12. I think simply multiplying the interest rate by the compounding period as you did is not the way to compute compounded returns.
I agree that TFB and Brad’s arguments make perfect sense as in my previous response. However, I do feel that their arguments, as well as yours, represents one of many scenarios, i.e., the whole $1000 is used to either pay off debt first and invest entirely after the debt is gone, or a portion of it is used to pay off debt and invest the rest. My case is slightly different. What I considered is a person puts off investing simply before there are debts needed to be paid off. In this case, the person may say “Well, since I have a debt, I need to pay it off first, so I can afford to invest $100 a month. I will start investing $100 after my debt is gone.” In this case, the person is not investing the whole $1000 used to be used to pay debt and chooses to invest only $100 and use the rest of the $900 for other purposes. We couldn’t rule out this case, could we? If you agree that this indeed could happen, then my argument is valid: investing should never be delayed. You can’t always expect people to invest all the debt-payment money once they are debt free. They could well use part of the money for other things they were not be able to do when they were in debt. You use one assumption ($1000) and I used another ($100).
I am not suggesting people should go ahead investing no matter what the debt situation is. That’s not true.
You needed $10000 above your means to accumulate your debt. Perhaps that’s your first problem to solve.
If you have to add to your debt at any time in the future, then the whole plan is negated.
I suggest you calculate your Net Worth and work from there. Debt payment increases Net Worth @ 18%, Investing increases Net Worth at 10%
Sun,
Thank you for responding. My last post did not appear to make it up so I hope this doesn’t double-post
To your points:
“since I invest monthly instead of annually, I will break that 10% annual return into monthly returns and compound the interest every month instead of once a year.”
This is a mathematical error
Looking at the link under the 10% number, you are investing in stocks or index funds so regardless of whether you reverse compound the 10% per year and then compound it or do a simple interest rate, you’ll still end up with 10% at the end of the year. Once again – these are stocks with a calculation of annual return NOT a compounding interest rate
To simplify this example, lets use a $100 stock that has a 12% annual return. The stock price going up 10% – so $100 x 1.10= $110 right? You’ve just made $10. That’s all it means. If you bought every month There is a chance that the stock fluctuates up and down so you could make a higher return with market timing or that it is not flat line growth but we are talking about long term which makes this irrelevant.
In the short term it would be possible to make more but this evens out.
As an example lets take a look at possible stock pricing:
Scenario 1 Scenario 2 Month
$100 $100.00 1
$101 $100.83 2
$99 $101.67 3
$103 $102.50 4
$105 $103.33 5
$107 $104.17 6
$104 $105.00 7
$106 $105.83 8
$108 $106.67 9
$110 $107.50 10
$111 $108.33 11
$112 $109.17 12
$110 $110.00 (end of month 12 plus 1 day or exactly 1 year later)
There’s your 10% – if you had invested every month you would make more money in some months and would even lose some in others. The point is that it’s irrelevant over the long term but there is no way you can pretend to have monthly compounding effects without decreasing the monthly rate of return to compensate thus making it the same.
You simply can not change the rules.
That is what the Kiplinger’s article is talking about. You can play with the formula trickery all you want but they are saying the stock indexes will go up 10.4% over the course of the ENTIRE year.
Now the other part you obfuscate is the psychological barrier. You say that someone in debt will decide to invest $100 but is willing to repay $900. Investing at a cost of $106 to make $75 doesn’t make sense.
What does make sense and what my advice would be is – to pay yourself back (with interest) at the end of your savings freeze. You can borrow your own savings at 10% or borrow from the credit card at 18%. The mistake you are highlighting is that people don’t think of borrowing from their investing/savings as a loan.
If you stop investing the $100 per month to pay off a debt faster then pay yourself back the $1375 you would have invested. You still make more $30 more this way and are better off in the long run
I, too, would like to know where the other $900 goes after the debt is paid off. I would argue that a person with an 18% loan cannot “afford” to begin investing until that debt is paid off — precisely because there is a debt to be paid. Even if you take just a small amount of the extra $900 that will now be burning a hole in your pocket and put that toward investing, you will surpass the scenario where you start with $100 at the beginning very quickly.
Again, the reason why I don’t think your argument is sound is because the debtor CAN’T AFFORD to invest BECAUSE of the high monthly obligation.
Regarding compounding, I believe it all depends on how we look at the change of price. Since we are used to calculate performance on an annual basis, annual compounding seems to make sense. However, stock prices change every day. For example, if at the beginning of the month, the price is $100 and I get 10% return for the month, the price will be $110 when the next month begins. If I get another another 10% return, my gain of the month will be $11, that’s monthly compounding. Looking at the two-month period, the price goes from $100 to $121 and you can say you get 21% return for two months (or similar extend the period to 12 months), or you can equivalently say you get 10% return every month when compounding monthly. At the end, both methods will give you a gain of $21. The results are the same, as you said with the 10% example. But since I am making 12 monthly investments instead of one annual investment, using monthly compounding I believe is more accurate as each monthly investment will have different compounding period. By using monthly compounding, I didn’t artificially inflate the number, it’s for the convenience when I don’t have a whole year.
Now, the other question. What I wanted to say with this post is that even a small amount of investment every month could make a big difference over a long period of time. I chose to use $100 or $50 instead of $1000 is just to show accumulating long term wealth is not difficult, even for people in debt. Saving $1000 a month is one story and saving $100 or $50 is another. The latter is much easier to do than the former. For a person who can afford to make $1000 debt payment every month, I can’t see why he/she can’t invest $1000 a month. However, as circumstances change (from in-debt to debt-free), people’s priorities and desires will change. It could happen that part of the $1000 will be used to do other things that are not related to growing wealth (buying a nice car or eating out more often for instance). Where does that $900 go? I have no idea. You, and others, are making an assumption that the entire $1000 will be invested after the debt is paid off. That could be the case in reality for a person determined to save and invest. It could also be another case that $500 of the $1000 is used to buy other stuff every month and only $500 is invested instead. I, on the other hand, assume a different situation: invest a small amount, but be consistent. Is it psychological? It may well be in my opinion.
If we only look at the numbers, everybody, including me, can see what’s the best approach, which I never dispute.
A couple of points:
“However, stock prices change every day”
They do but you are using an overall gains number of 10.4% and long term investing. That includes days like yesterday when Akamai loses 20% and days when everyone seems to be doing amazingly well.
If you are suggesting people day trade or swing trade with that $100 that’s a whole other issue but you (and Kilpinger’s) are suggesting someone consistently invest $100 per month and over the long term they’ll get a return of 10.4%
In fact the Kiplinger’s article you use to get the 10.4% number (http://www.kiplinger.com/magazine/archives/2007/05/triple.html) says:
“Assuming annual investment gains of 10.4% — the average return of U.S. stocks since 1926 — you’ll earn 200% in just 11 years.”
They came up with the triple your money article number by taking an overall gain – 1.104^11 = 2.969 meaning for $100 now you’ll have $296.90 (196% gain).
If you get the simple rate of return with 11 years (just divide by 11) that’s 17.8%.
Looks nice doesn’t it? That’s the actual point you’re trying to make – at 30 years you make more than 18% by comparing 1 year vs 30 years.
That’s a maor fallacy – let’s just compare the investment balances at the end of 13 months (since afterwards the loan is no longer in place.) In scenario 1 you have $1300 saved up plus $75 in interest earned minus an extra $106 in interest spent. You’ve just LOST money over the short term even though this $1269 will end up being about $30k in 30 years because you’ve invested $1300 but are now only compounding on $1269 for the next 29 years.
Consider the same dollars saved – at a later point in time (in months 12 and 13). Rather than dumping $100 x 13 months you back track by putting in the $1300 in missed savings (and possibly the $106 you saved on loan interest payments). In this scenario not only is the $1300 put in after a year of inflation (cheaper money) but it will earn you more than the effective $1269.
Oops – the reader that invests the $100 per month from the beginning just made $700 less over the long term than the guy that paid off the loan and then played a quick catch up.
If you are comparing someone “starting investing” meaning taking that $100 and only doing that with starts and stops – sure… point taken. Psychologically, you could be right. Financially and practically, it’s bunk.
Well, what you’re basically saying is that investing something is better than investing nothing. Not exactly groundbreaking news.
I could also say, Susie has 10 dollars. How would she be better off financially should she buy a hamburger or invest it at 10% compounded monthly for 30 years?
Or rather, since we’re just making up numbers and increasing time on one side of the equation to support our pre-determined cause, why not take it to the extreme?
Pay 150.71/mo for 360 months, and you only pay, in the grand scheme, a pittance in interest — $44,255.07
But just think, you’ve invested $849.29/mo for 360 months at 10% annually, racking up $1,919,949.03.
By paying off your debt, you’re giving up the opportunity to be millionaire!!
Bubba: What I wanted to say when I wrote the post was already clearly displayed in the post:
“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?”
This is my main assumption. My example may not be a very good one, but I still put paying off debt the highest priority. Otherwise, I could use your numbers ($150 for debt and $850 for investment). That’s not true. You can take it to all the extremes, but that’s not what I suggested. In fact, my only suggestion is investing shouldn’t be delayed, even when one is going through some times (like paying credit card debt). If this is wrong, then maybe I am wrong from the beginning.
To me as I said my previous response, it’s hard to imagine why a person who can put $1000 in debt payment can’t save and invest the same amount after the debt is gone. However, again, circumstances change and people’s priorities and desires change. Paying off debt with 18% rate could be urgent, but does the same level of urgency always apply to investing? I don’t know.
And “that money is well spent because they’d have been investing the rest of the $1000 each month at 10% and so would have racked up over a million dollars.” You are paying $44K to get a million. You are paying $44K to get $10K! The one million you get has nothing to do with how much you pay for the $10K debt!
“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 donâ€™t spare $50 and invest it while battling the debt?â€?
You can feel what you want but that doesn’t make it fiscally sound. Pay off your high interest debt, then catch up on the investments made. Compare your short term actions as they actually affect the long term without mixing the returns up.
“In fact, my only suggestion is investing shouldnâ€™t be delayed, even when one is going through some times (like paying credit card debt). If this is wrong, then maybe I am wrong from the beginning.”
Exactly.
“Paying off debt with 18% rate could be urgent, but does the same level of urgency always apply to investing? I donâ€™t know.”
That should be the advice. To use that same sense of urgency to repay yourself – not to waste money on high interest rate loans
Fiscally sound advices say one shouldn’t get into credit card debt in the first place, yet hundreds and thousands people are doing just the opposite: use their credit cards irresponsibly and only to fall behind their payments. Not everybody follow the sound advices, otherwise, the whole discussion would never happen.
This is terrible advice – especially on a personal finance blog. Your example is flawed because the different situations put different total amounts towards (debt reduction + investing). Why would you use those situations? You CAN’T compare them and expect to make any logical conclusion.
Simply put:
Borrowing at 18% to invest at 10% is an obvious mistake.
PAY OFF YOUR CREDIT CARD DEBT – THEN INVEST
Please do everyone a favor and take this post down. I wouldn’t want anyone believing you.
I have stated many times in my previous responses my intention of the post. I am not suggesting borrowing at 18% to invest for 10% return. I won’t even use money borrowed at 0% to buy stocks, let alone 18%. The
only thing I wanted to say is investing should never be delayed, even when one is in some tough situations, such as paying off debt. It will an ideal that the same $1000 used to pay debt are invested when the debt
is gone. But do you believe that will happen to every person in debt? I don’t. I could use a couple of hundreds out of that $1000 to eat out a little more often or go to movies, or do things that I wasn’t able to do when I was in debt. Can this happen? I believe so. There could be many excuses of not to invest as early as possible and paying debt is just one of them that I could imagine.
“I have stated many times in my previous responses my intention of the post. I am not suggesting borrowing at 18% to invest for 10% return. I wonâ€™t even use money borrowed at 0% to buy stocks, let alone 18%.”
If I borrow $600 at 18% (about 1.5% per month)
Scenario 1
I pay $509. Next month I’ll owe $101.50 I invest $100.
Scenario 2
I pay $609 but borrow $100 that same day to invest it. Next month I’ll owe $101.50
Where’s the difference? Either way you just borrowed that $100 at 18% whether its on an old loan or new loan.
All you’ve done is obfuscated it by taking the loan into the long term.
You ARE suggesting borrowing at 18% in order to invest. At the very least don’t lie or pretend that it’s any different.
Lastly -
“There could be many excuses of not to invest as early as possible and paying debt is just one of them that I could imagine.”
There are also many excuses for not getting a free $4 smoothie before the promotion runs out such as not taking a $6 cab ride.
It’s not an excuse sir – it’s a smart choice of action.
Both of these can be accomplished at the same time with a little bit of discipline
Take the little bit discipline,I think it need more discipline to accomplish it well. Just make it happened.