Alright, so you have some credit card debt, or maybe you have a mortgage for your home, or maybe you have student loans. But, you have some extra money to throw down. Should you invest it, or pay off your loans? Well, this really depends on what type of debt you have, the interest rates on your loans, as well as your risk level.
Good Debt and Bad Debt
I first heard these terms when reading a book by Robert Kiosaki, “Rich Dad Poor Dad”. When I hear about people borrowing money to buy something, these are the terms I associate it with. So what is Good Debt? Simply, this is a loan to make purchases that will pay for themselves. The investment you are buying will, ‘pay for itself’, in that over a period of time, it will pay off the borrowed money, and then continue making money to pay you. Contrastingly, Bad Debt is debt that you take on that doesn’t pay itself down. This is borrowing money to purchase something, gaining ownership of that ‘thing’ and then making payments towards that purchase oftentimes with interest. This grows into a worse situation when selling the item returns less than its purchase price. This is a concept that many keep in mind when making purchasing decisions. So what are some examples of Good and Bad Debt?
Some easy ways to understand Good Debt is in the form of a mortgage on an investment property. The key is that the collected rent pays the mortgage payment as well as other associated costs of the property, eventually paying off the mortgage and then paying you. This debt could also come in the form of stocks. If you have a personal loan or a HELOC at a low interest rate, and you aren’t using that money, you can make strategic mutual fund investments and that yield much higher interest and make money from funds that you aren’t using. A HELOC is a home equity line of credit, a loan on a percentage of equity that you own in your home. Often this loan comes at a low interest rate, that people can use to make expensive purchases or investments. Another way is using borrowed money for development of a small business. As long as your business produces enough for the loan payment and hopefully a little more, its worth it. Essentially debt that offers you a return can be categorized as Good Debt!
Now we talk about Bad Debt. The stereotypical example of this is purchasing a vehicle, especially a new vehicle. You take out a loan from a bank or the dealer themselves, drive off the car lot and already your new car is worth less than what you just paid for it. Now not only will you pay more for the car than its sale price, over the course of the loan, but if you decide to sell the car, you’ll see that its value has depreciated annually. (Unless of course, if the car you purchased turns out to be famously rare and appreciates by 200%) Another type of Bad Debt I want to include is credit card debt. Generally credit card companies charge ridiculous interest rates and thus I strongly suggest using a credit card like you’re using your own cash. This way you have the luxury of simply using a card for your purchases, but you can pay it off in full when the bill arrives. Only paying the minimum payment and compounding that 15% – 20%+ in interest is something that can quickly balloon. Why would you want to pay 15% interest on that coffee you swiped for at Starbucks? Here’s the thing, you wouldn’t. So keep your spending habits in check and use your credit card like you’re using a debit card.
Once you’ve classified the type of debt you have, I suggest taking a good look at the debt you consider to be Bad Debt. This is truly owed money that could otherwise be used to produce more of your own money. If you have multiple types of Bad Debt, a common payoff strategy is to look at the loan with the highest interest rate and focus your monthly cash towards lowering it. Pay towards the principle amount and get it off your plate. Go in this order until all of your high interest debt is paid.
Investing With Low-Interest Debt
Once you’ve taken care of your high-interest loans, but you still have some low-interest loans, you might wonder if its okay to begin investing. These low-interest loans can take the form of the debt we’ve mentioned above such as car, credit card, or even student loans. However, lets say you only have one of these with around a 7 – 9% interest rate or even lower, and you can pay down the principle fairly easily, within around 18 – 24 months with your regular loan payments. Now, you can either pay down your loan quickly, by making extra payments towards your principle, or you can do something else with that money. Lets say that you’ve found an investment opportunity where you can make 10 – 12%. This can be from peer – to – peer lending, through purchasing a rental property, or maybe even buying crypto currency. Remember that all of these and any other types of investments require their own research and understanding before you put your money towards it. However, if you found an investment that grows at a higher percentage than your debt, it would be useful to continue making your regular debt payments, while investing in high-return opportunities. An interesting way to think about this is in terms of compound interest. Compound interest works by re-investing your gains over a long period of time, and the earlier you begin investing the greater your return. Say you found an investment that takes $1,000 to start up and returns 8% annually and you add an extra $1k each year. In 10 years you’ll have $17,804.41. Now lets say you only invested for 5 years, that yields you $7,805.26. My point is that starting to invest as early as you can does have its benefits. However, you want to make sure you have your other debt in control, you’re building enough money to begin investing, and you do your research on what investments make you feel the most comfortable.
What’s Your Personality?
When it comes to your personal finances, your own thoughts, goals, and attitude all come into play. While one might prefer paying down all of their debt obligations before investing, another might prefer investing once they have controllable debt. What might be significantly important is taking the time to learn about your investment options, keeping track of and categorizing your debt, and just taking the time to learn about yourself and your feelings toward spending your money. This is especially true if you’re taking out a loan to invest, you want to understand your comfort level. I mentioned above that you might use a personal loan or HELOC to invest in a mutual fund if it returns higher than your loan payment, however I wouldn’t personally do that since it doesn’t match my attitude towards investing. That doesn’t mean that others won’t find it a great way to use their equity. Understanding how you personally feel about money is key in learning how and when you should invest, the types of investments you should make, and furthermore what you want your finances to look like.