Ever wonder why so many financial advisors push you to start saving right now, even if you are burdened with insurmountable debt? The answer is simple: Financial advisors are commissioned salespeople. If you don’t buy what they sell (the investments) they don’t get their commission (trailer fees).
Many advisors will emphasize that the power of compounding outweighs paying a few bucks in interest every month. Which is right; but a few bucks in interest is unlikely for most of us (the average American carries $22,100 in debt). As a result, investing early and making credit payments will hinder your lifestyle and keep you in debt.
We can see whether the argument is valid once we know our Cash Dilution Rate. This rate essentially tells us how much of our after-tax dollars we lose to the credit debt we have. So, the higher the rate, the more we pay to creditors; the lower the rate, the more of our after-tax dollars we delight in and, therefore, can afford to invest without sacrificing our lifestyle.
Taking a closer look, we can consider someone who earns $2,000 in after-tax income. Match this to the average American debt of $22,100 that carries an average rate of 13.35%, and this individuals sees only $1,732.86 of her $2,000.
For a better appreciation of this situation and how severe it can be, let’s pretend her advisor encourages her to invest a “modest” $250 per month. Combined with the $267.14 she pays in credit debt, she is left with less than $1,500 to delight in the rest of her life. Even though she started with $2,000 she loses an additional 25% and has much less to pay for other expenses like rent, mortgage, entertainment, etc.
But, if this individual could eliminate all of her debt, the $267.14 in monthly savings could be earmarked for her investments. What hurt does this cause to her long-term savings? That depends because there are two ways to tackle this scenario.
The first thing to consider is whether this individual can indeed afford to invest $250 per month. Assuming she can, then she should really refocus this money toward debt repayment (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). By using this extra $250 to repay debt, she will reduce her repayment schedule from 57 months to a small less than 25 months. That means that in 3 years, she invest both the $250 that the advisor recommends and the $267.14 that she is already paying toward debt, for a total of $517.14 per month.
The other factor to consider is timing. If she has only 15 years left to invest, what happens if she postpones her start date by 3 years while she repays debt? The impact is negligible, in fact. By repaying all of her debt first, she might only be left with 12 years, but she will be able to invest more once the debt is repaid ($250 + 267.14 instead of just $250 today). This translates into additional, compounded savings of $38,283, assuming a constant rate of return and that she can still invest $250 + 267.14. Not only does she come out ahead to the tune of thirty-eight thousand dollars, but she is debt-free, allowing her to weather unforeseen financial turbulence in the years to come.
Now let’s assume that after sacrificing so much for three years while repaying her debt, she doesn’t want to invest the full $250. Instead, she will take $125 and buy something she enjoys, like shoes, and invests only the remaining $125. Even though she has given up half of her originally plotted savings, she is still investing $392.14 ($125 plus the $267.14 she formerly paid to debt). The impact? Also negligible, even though she “lost” three years of compounded growth. In dollar terms, she will be farther ahead by $7,167 if she repays all debt and invests only $392.14, compared to starting today with $250 per month and still having the debt in three years.
As evidenced above, accelerating a debt repayment plot should often take priority over investing for the simple sake of future compounded growth. This statement contradicts a lot of what has been written already about wealth building, but the illustration above shows us just one way a debt-free lifestyle allows us to delight in greater wealth down the road. Of course, there are some rare instances where an investment plot should be used in conjunction with a debt repayment schedule but, again, those situations are rare.