Should I Stop Investing To Pay Off Credit Card Debt?
"One of the biggest mistakes I see a lot of people make with debt is prioritizing their debt payoff in the wrong order." - Jen Swindler, MFPA, CFP®, AFC®
You’ve probably seen nothing but flashing headlines about economic shocks all year. Inflation, interest rates, crypto drops, and a recession, to name a few. As an investor, you're probably wondering, "Should I stop investing to pay off my credit card debt?"
Both are important goals for your long-term financial success. However, to tackle both, you need to understand the challenges and implications they can have on your overall financial plan.
Here's Jen Swindler’s, Senior Wealth Manager take on it:
The Key Differences Between Investing and Paying Off Debt
Investing is a way to save money for the future, preferably in assets that appreciate over time, such as stocks, bonds, ETFs, and mutual funds. Investing is an essential part of preparing for your financial future.
In contrast, debt is money that you have already spent, that you owe to a creditor, and on which you are being charged interest, typically accruing monthly – this is referred to as an APR on your statements (Annual Percentage Rate). If left unpaid at the end of your credit card billing cycle, interest charges will be added to your previous debt balance, which will increase the total amount owed and generate more interest expenses.
Reasons to Invest:
As a rule of thumb, it makes sense to invest if you can earn more growth on your investments than the rate you are paying for your debts. For instance, if you have a mortgage with an annual interest rate of 5% and a stock market index fund that is expected to return 10% annually, you would be better off investing your extra money in the index fund.
On the other hand, if you have credit card debt with an interest rate of 20%, you would be better off using your extra cash to pay down the debt than investing it in an index fund. Unfortunately, things are not always so straightforward. Investments may be volatile, and past performance is not a guarantee of future results. The index fund in the example above might gain 10% this year and lose 10% next year. Even while there are assets with a guaranteed interest rate, such as bank certificates of deposit (CDs) and U.S. Treasury bills, their rates of return are often low and rarely exceed those charged by credit card companies and other lenders.
Another factor is more psychological: your risk tolerance. If you don't mind the possibility that the value of your investments will fluctuate with the market, sometimes increasing and sometimes decreasing, you are a better prospect for investing more aggressively than someone who worries about what the market might do tomorrow.
Why you should pay down your debt:
There are a number of good reasons to pay down debt instead of investing. As mentioned above, the first is that if your debt has a high interest rate, you might come out ahead. This is very true when it comes to credit card debt. On average, credit card interest rates are 19.62% and are variable rates, meaning they can go up based on market conditions. Few investments can beat that kind of return.
Your credit score is another good reason to pay down debt. This score can be crucial if you want to borrow money in the future, such as for a mortgage or auto loan. If you can obtain a loan at all, you may be required to pay a higher interest rate if you have a low credit score. Even other aspects of your life, such as how much you pay for insurance, whether a landlord will rent to you, or if an employer will hire you, can be affected by your credit score.
Numerous factors influence credit scores. Your credit utilization ratio — the amount of credit you are now utilizing relative to the amount of credit you have available — accounts for a significant portion of your FICO score.
A person whose credit cards are completely maxed out, for instance, is likely to have a considerably lower credit score than someone whose credit cards have been paid off or at least paid down to a more reasonable level.
Similar to investing, psychology plays a role in this decision. Even though you might earn more money by investing, you may be better off paying off your debts if they keep you up at night.
Reasons to do Both:
Paying down debt and investing are not mutually exclusive options. You can do both, and sometimes you should.
For instance, if you do not already have an emergency fund, you may wish to utilize a portion of your money to create one and the remainder to reduce your debts. A low-risk and highly liquid investment, such as a money market mutual fund, is an excellent place to hold your emergency fund.
How to Get Rid of Debt:
If you've opted to pay off your bills with your extra cash, the next question is how to proceed. If you have enough money to pay off what you owe, the solution is straightforward: simply pay it off. However, if you have limited funds, you will need to establish priorities. In general, you will get out of debt more quickly if you begin by paying off the debt with the highest interest rate and work your way down. For instance, if you have balances on two credit cards, one with a 20% APR and the other with a 15% APR, pay off the balance with the 20% APR first.
In the case of credit card debt, you may also have the option of transferring your balances to a card with a reduced interest rate and subsequently paying off the amount. Some balance transfer credit cards offer promotional periods of 0% interest for six to eighteen months, allowing you to pay down your balance more quickly because you won't be charged interest.
A debt consolidation loan from a bank or other lender is a further alternative. You borrow sufficient funds from the lender to pay off your other debts. Now you have only one debt to worry about, ideally with a lower interest rate than your previous obligations. You can then utilize your additional funds to begin repaying the loan.
If you have a lot of debt:
If your extra funds are not enough to make a dent on your debt, you may need to explore more serious steps. First, contact your lender if you are having difficulties making even the minimum monthly payments on your credit cards or other loans. Your provider may be willing to cut your debt's minimum payment or interest rate.
If the psychological win of paying off a low balance credit card will be highly motivating for you, it may still be the best option for you. However, because interest rates determine how expensive your debt is, you should use them to determine whether you're better off investing your money or paying down debt quickly.
If you have debt with an interest rate greater than about 5 or 6 percent, you should prioritize paying it off before investing. If your debt is below this rate, pay only the monthly minimums and focus on investing your assets in a well-diversified portfolio set up according to your goals, risk tolerance, and time horizon (after building an adequate emergency fund).
I hope this information was helpful. If you have any questions feel free to reach out. I’d be happy to chat with you.
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