Friday, April 20, 2012

Money – Pay off Debt or Invest

Most of the time financial guidance is pretty simple.  You a few easy questions.  Do you have any credit card debt?  If the answer is no…then do you have a mortgage?   If they answer yes, I ask what interest rate is it at?   Sometimes the best means for your money is to refinance and pay off the mortgage quicker.  Refinancing at a 30 year mortgage I can never recommend.  I cannot ever recommend getting a 30 year mortgage on any home. A 15 year mortgage is my standard recommendation.  I wrote about this in my housing rule of thumb article.


I would ask if they trade stocks before?  I proceed to ask what they feel they can honestly get as far as rate of return on investment.  Most will say they do not know or quote some CD price.  You cannot expect to get great returns without knowledge in finance.  You can get slightly below average returns by purchasing an index fund such as SPY or a mutual fund that index the market.  And you can have your money siphoned away by purchasing certain mutual funds.  However, when I worked at Fidelity the S&P 500 index lost money for last 10 years.

Why slightly below average returns?  Because if you invest in any type of mutual fund or ETF there will be some sort of management, commission, or transaction fees.  This will typically result in slightly below average returns for a particular index.


Paying off your credit card debt or mortgage and having the correct financing on your house i.e. 15 year mortgage is never a bad idea.  If you say to yourself...I cannot afford it.  Instead ask yourself, "how can I afford it?"  How can I afford it doesn't mean out and finance incorrectly.  The main problem that American's faced they were over leveraged.  They also found out quickly that owning a house can be a big money loser.  If you rent and have no debts...be glad.  Many people would love to be in your situation.  Just remember...the present is always the best time to start to educate yourself about money and investing.


When it comes to investing it is really quite simple.  You find out the surest way to make the largest returns on your investment with the least amount of risk.


Let's look at the following scenario


Debt - Liabilities
Credit card debt $10,000 @ 21%
Mortgage debt $100,000 @ 5%


Assets
Cash emergency fund - $5000

This person wouldn't be able to start investing until they get that credit card debt eliminated.  If you have $5000 in an emergency fund, my suggestion is to spend it all to pay off your credit card debt.  You don’t need any emergency fund, if you are already in the state of emergency!  Anyone who has credit card debt is in a state of emergency!  This is where budgeting become the utmost importance.  Creating a budget is really quite simple.  Let's take at our pretend income statement:


Income: $2000   Expenses: $2100
Net: ($100)


If you see this situation...then you will never get out of debt by continuing on the same path.   What can you do about it?


Two things that I would suggest.  First of all, make certain you are paying at least the minimum payments on your credit card debt.  If you have been doing that then call the credit card company and TELL them politely to lower your interest rate.  If you went from 21% to 15% you'd save $50 almost instantly.


Income $2000   Expenses: $2050
Net: ($50)


If you used your emergency fund cash to pay off half of the credit card debt, then now your situation would be


Income $2000   Expenses: $1988.35
Net: $11.65


That is progress!  What about my emergency fund?


I’m sure you were taught you need one, but the truth is that your credit card is your emergency fund in this situation.  Getting out of this debt is your number one priority.  If something bad happens again that costs you $5000 then you are back to where you started by charging your credit card.  Regardless if you kept the money in savings or paid off half of your debt.  The difference is that if you paid off half your credit card debt, your monthly cash flow would have increased.  Therefore you are in a better position than if you kept your money in savings.  Why?  Because credit card debt is very expensive.  The interest alone can put a heavy burden on you financially.


How bad is credit card debt?  You can go to my calculator page to see how much it will cost.  However...Let's take a quick look:


Credit card debt $20,000 @ 27% = $5,400 per year or $443.84 per month
Credit card debt $10,000 @ 21% = $2,100 per year or $172.60 per month
Credit card debt $10,000 @ 15% = $1,500 per year or $123.29 per month
Credit card debt $5,000 @ 21% = $1,050 or $86.30 per month
Credit card debt $5,000 @ 15% = $750 or $61.64 per month
Mortgage debt $100,000 @ 5% =  $4,895.67 first year of interest


As you can see above...credit cards will destroy your wealth.  Paying off your credit card by not having that $5,000 emergency fund would save you $86.30 per month at 21%.  The quickest way to reduce your debt with credit cards is not paying them off.  It is getting that rate down!  That is real money, and that money can be used to pay off the debt faster.


The problem is spending habits.  Most people have luxuries that they do not need.  What is a luxury?  Everything besides food, water, shelter, heat/electricity, and transportation (whether a bus, walking, bike, car).  It is almost like the difference between people who have cable and those who use Hulu.  If you cannot wait one day to watch your favorite show for free on Hulu, then you might have a spending problem.  The convenience tax is very high, and for someone who is in debt, every dollar counts.  Don't waste it!


Disclaimer - The math doesn't account for everything, these are fictitious examples that are realistic in nature.  Be sure to do your own research and studying.  After all, knowledge is one of the easiest ways to lower risk, and become wealthy.  An idea can be worth billions...

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