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Updated on Wednesday, November 4, 2015
Wondering whether you should pay off your credit card debt or invest your money in the stock market? This question is one of the most common questions I receive as a financial planner, so let’s put this issue into perspective and finally get some answers.
Anyone can answer this question once framed appropriately. First, you need to understand the impact that stock market returns (both negative and positive) and interest rates (on your debt) have on your money. Once you do this, the information you really need comes largely from the variables involved with the debt. This includes things like the type of debt you have, the interest rate on what you owe, and the current balance.
These variables are more important in understanding whether you should pay off something like high-interest credit card debt or invest than any factors related to the stock market in any given year.
Understanding the Impacts of Long-Term Investing
Many people fear the stock market – and for good reason. We’ve had some pretty serious market crashes over the past 15 years. But the way I see it, we’re lucky to have experienced such downturns. Many people now approach investments with caution, and that’s a good thing.
Let’s dig into the numbers a little bit, though, to see how these positive and negative investment returns actually impact our money. For the purposes of this article, we’ll assume that the “stock market” is the S&P 500 Index, as it’s one of the most common indices used in the US. All investment returns used here will be historical returns from the S&P 500.
Let’s look at the time period that caused most of this fear in recent years: 2008. If you invested $5,000 in the stock market on January 1, 2008, you would have had $3,172 on December 31, 2008 – or a loss of 36.55%. Not a great result.
Now let’s take a broader look and see what would have happened if you invested that same $5,000 in the market five years earlier on January 1, 2004. On December 31, 2008, you would have had $4,890 – or a loss of 2.19%. It’s still a loss, but one that’s much more manageable in the grand scheme of things.
But if you invested that same $5,000 on January 1, 1994, you would have had $5,323 on December 31, 2008. That’s a gain of 6.46%. As you can see, the longer you were invested, the better your chances of coming out with a gain.
Of course, not all 15-year periods will produce the same results. The point here is that our investments do have the ability to withstand even the most poorly performing markets if we invest for a longer periods of time. That said, there’s no guarantee that we will experience positive investment returns in any specific timeframe.
Understanding the Impact of Paying Interest on Your Credit Card Debt
Unlike stock market returns, which are not guaranteed, paying down debt is as close to a guaranteed return on your money as you can get. This is true because for every dollar of debt you pay off, the less interest you pay the loan company.
In other words, the faster you pay down the debt, the more money you have to use elsewhere. Let’s look at an example.
Let’s say you have a credit card balance of $5,000 with a 17.5% interest rate. If you pay $125 per month (without making any additional purchases on the card), it will take you about 5 years (or 61 months) to pay off this card.
During that time, you will have paid $2,557 in total interest. To be clear, you will have paid the $5,000 debt balance plus interest of $2,557, for a total repayment of $7,557.
Choosing Between Investing and Credit Card Debt Repayment
Combining the two examples above can provide us with a solution to our question. Put yourself in this position for a minute. Say the date is January 1, 1994 and you have $5,000 sitting in your bank account and another $5,000 in credit card debt. You’re wondering what you should do with that money. Do you invest it or pay down your credit card debt?
And for the sake of this conversation, let’s assume you’re already taking advantage of saving money in a 401(k) plan if one is available and your employer offers a matching contribution. A good rule of thumb is to make that form of investing your top priority: contribute enough to get the match.
As mentioned above, if you invested that $5,000 in the stock market on January 1, 1994, you would have had $5,323 in 15 years. That’s a 6.46% compound return on your money. Not bad.
If you were also paying off your credit card debt using a minimum monthly payment of $125, you would be debt free in 5 years – but would have also paid the aforementioned $2,557 in interest to the credit card company.
What if you took that $5,000 and paid off your debt in one lump sum payment on January 1, 1994? By doing so, you immediately guaranteed yourself a savings of $2,557, because there would be no need to pay interest on your loan. You also wouldn’t have to pay $125 each month for the next 5 years.
What to Do Once You’ve Paid Off Your Credit Card Debt
So what do you do with that additional $125 each month? Now that you aren’t forced to repay that credit card debt, you can do whatever you want with that money.
The smart investor might set up an automatic contribution into an investment account of $125 per month. But you could just as easily split it in half and put $62.50 into the investment account and save the other $62.50 for a trip in a few years. In 33 months, you’d have $2,000 for a nice trip down to a tropical paradise – and you would be steadily adding to your investments at the same time.
There is no one-size-fits-all answer to this situation, and that’s why it gets confusing. The right choice for you will depend on the variables for your debt and your long-term goals.
I do know one thing for sure. The answer comes in the form of taking action. Take some time to understand your financial situation and choose a path that makes sense for you.