Should you focus on debt reduction, saving or investing? It’s one of the most commonly asked questions of those seeking help with improving their finances. It even came up during the Money Matters Tweet Chat hosted by Black Enterprise last week, where I joined personal finance expert and BlackEnterprise.com Contributor Jennifer Streaks and BlackEnterprise.com Digital Producer Darren L. Sands to answer questions about credit, debt reduction and other money issues.
It’s a trick question. The fact is, paying down debt is an investment—in fact, everything you do with your money is. The only question is what the returns will be on the investment choices you make with your money. Everything you do with your money—from spending and saving to giving and gambling—causes you to become either more wealthy or less wealthy. However, debt reduction is one of the best investment decisions you can make, because every dollar of debt you eliminate frees up funds for saving and investing in assets that can appreciate and earn interest for you. And if you’re being charged interest on your debt burden, as the overwhelming majority of us are, debt reduction is the only investment with guaranteed returns. There are two primary reasons this is the case.
First, every dollar you have to devote to servicing debt payments is one less dollar you have to save toward your financial goals, whether that’s a down payment on a home, financing a college education or launching a business. For example, if you are carrying a total of $8,000 in credit balances—just below the average credit card debt per household for 2012—that’s money no longer available to you for other financial goals. If you used your credit card to invest in purchases that helped to improve your financial situation—for example, to finance a trip to another city to land a big contract for your business—then it may have been a worthwhile investment. But if you’re like too many of us, you used your credit card to purchase depreciating assets—clothes, dining out, entertainment, etc. If you used credit to finance those payments without immediately paying down the increase in your balance created by those purchases, that was a bad investment.
Second, and more to the point, is that for every dollar of debt you pay down, you free up money you are currently devoting to paying interest and fees for the privilege of carrying that balance. For example, if you’re paying $100 a month on that $8,000 balance, with an APR of 15%, you’ll pay nearly $2,400 in interest payments over the next two years alone. Paying down the debt immediately frees up that money for other uses, ranging from shoring up your emergency savings to making larger contributions to your 401(k) or other retirement savings accounts.
This is what I mean when I say that debt reduction may be the only investment with a guaranteed return. If you have the choice of investing $3,000 in a mutual fund with annual return of 8%—a very solid rate of return—or using that money to pay down a credit card balance with an interest rate of 12%, pay down the credit card debt. That way you save the money you were previously using to make credit card payments and interest, and can begin using it to invest in a mutual fund. In other words, you are paying down debt in order to finance your investments. More over, no one can say for sure that the mutual fund that delivered an 8% return in 2012 will maintain that performance in 2013—you’ve heard it before: past returns are no guarantee of future performance. However, it is guaranteed that paying down your credit cards will eliminate the interest payments that you’re making.
So here’s my bottom line: You must pay yourself first, starting with building up an emergency fund equal to at least 9 months of your annual household expenses, in case of loss or extended interruption of income. You must save for retirement, contributing as much as you can every month to a 401(k) or other retirement savings vehicle. But other than those two exceptions, make paying down your high-interest debt your top investment priority today, so you can free up more money to build up your savings and investment portfolio over time.