Debt is a widespread struggle in America. When speaking about building wealth, investing is a prevalent method. It is one that I push consistently as an accessible, hands-off method of building long-term wealth. However, this advice is usually directed towards people with little to no debt, using it to make better use of their income.
Many Americans stuck in debt wonder the same thing: should I invest while in debt? There is no binary answer to this, but the answer is yes for most people. In this post, I’ll go over why I think that’s the case and what exceptions exist to this answer.
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Why Not Invest While in Debt?
Debt Adds Stress
For many people, debt is a constant rain cloud looming over them. It feels like something inescapable. Finances aside, it’s not healthy to experience that kind of constant stress.
For people in this mental situation, prioritizing debt payoff over investing is easily worth it. Paying off your debt more quickly will allow you to feel better and put more energy into other things, such as investing.
Not Enough Spare Income
When in debt, there must be a plan to pay it off. This may be a 1-month plan or a 30-year plan. Regardless, payments will have to be made over time to pay it off.
These payments put additional stress on a person’s financial situation. It could result in a person having less money left over to use how they see fit or even make it difficult to pay for necessities.
For a person to be able to invest, they need money left over from their paycheck that they can afford to save for the future. If debt and other payments take up all of the person’s income, then there is nothing left over for investing.
Interest Rates
The other tricky part of debt is interest. Interest is an additional charge for the delay in paying off the debt. For example, if a bank loans an individual $1,000, they need to be compensated for letting the individual wait a set amount of time to pay them off.
Interest may only be a small percentage of the principal loan, but it compounds. Just as compounding builds wealth through investing, compounding takes wealth through debt.
Interest payments make it harder to invest because the longer you wait to pay off your debt due to investing it, the more you must pay.
Length of Loan
Another factor is the length of time you must pay back the loan. The shorter the period is, the more critical it is to focus on paying it back so that you don’t default on it. However, the longer the loan is, the more you will pay interest in the long run.
There is a balancing act between the two. In general, it’s better to focus solely on short-term loans to get them out of your way so you can move on to using your finances for other things.
Can Make Additional Payments
When paying off debt, you usually can pay more than the minimum. In general, this is a good idea as it pays off the debt faster and saves you on interest since you have the loan for less time.
If the option to make additional or higher payments is available, it is more tempting to prioritize the loan over investing.
Why Invest While in Debt?
If Return > Interest Rate
The purpose of investing is to build wealth over the long term. This will be done through compounding annual returns. This is historically a 10% average annual return for the stock market.
If this 10% return outpaces the interest rate, then it would be better to invest. If you earn 10% from the market and pay 5% towards debt, you still profit 5% annually.
Compounding Takes Time
Investing is also a long-term game. As mentioned, compounding is the heart of it all. But compounding takes a long time to make a significant difference. The earlier you start investing, the better.
It may only sometimes be the best idea to wait to get entirely out of debt to invest as you are missing out on that much time in compounding. Even one additional year of compounding can earn you tens of thousands of dollars over a few decades.
The goal of all this compounding is to build up enough wealth not to have to worry as much about debt in the future. You will have the funds you need to live how you want and not need as many loans. Taking the short-term stress of debt may be worth it to contribute to a future devoid of that stress.
Debt is Leverage
Though this isn’t for everyone, debt can make investing more powerful. Primarily, this is in the form of margin investing. Check out THIS POST ON MARGIN INVESTING to see if it’s right for you.
In short, margin investing is using a loan from your brokerage to give you greater leverage. This sort of debt will usually be short-term as an investor uses the margin for a quick return and pays off the loan and the small interest.
This is an essential point as it illustrates that debt is not always negative. Debt doesn’t always make it more difficult to build wealth. Sometimes, it can make it easier.
Debt is how many ultra-wealthy people become and stay ultra-wealthy. They use the wealth they already have as collateral to get debt. Then, they use that debt to gain far greater returns than they pay in interest.
This method of wealth-building isn’t for everyone. But it’s essential to understand the possibilities. The more you know your options, the better your chances are of succeeding.
If Debt is Already a Living Expense
When we think of debt, we think of additional payments due on top of living expenses. However, some debt is an expense you must pay to get by. This could be something like credit card debt.
For example, most people couldn’t afford to buy a house in cash, so they get a mortgage. A mortgage gives them a place to stay, and the monthly payments replace standard rent. Thus, a mortgage payment becomes a living expense.
If paying off debt is a living expense, and you can afford the payments comfortably, then investing will be a good idea. A living expense won’t go away anytime soon, and investing will help you build wealth while you’re paying it off.
Should You Invest While in Debt?
Debt can come in many forms. Each form has its unique challenges that influence the answer of whether or not investing is a good idea. I’ll cover a handful of common ones and my opinion on investing while in that debt.
Mortgage
Mortgage debt is the most common debt in America (https://www.bankrate.com/personal-finance/debt/average-american-debt/#average-american-household). For most people, it is the only viable method of buying a house. Plus, home ownership has been traditionally pushed as an essential step towards building wealth.
Mortgage debt is usually a very long-term debt. The average length of a mortgage is 30 years (https://www.rocketmortgage.com/learn/average-mortgage-length). This means you have a very long maximum time to pay it off, but waiting the entire 30 years means you pay the maximum amount in interest.
During these 30 years, assuming you have a fixed interest rate or a variable one that will only decrease, it is a fixed amount that is due. If you loan $300,000 to buy a house, including 30 years of interest, you will never owe more than you did last month. This means there will be no surprises of suddenly having more to pay off than you planned for. Stable, fixed debt is safer to invest during than variable debt.
The one upside about a mortgage regarding investing is that a mortgage is essentially just your rent. A mortgage isn’t an additional payment on top of your other bills; it replaces your rent payment. This gives you more financial flexibility.
The priority should be first to make sure you can afford slightly more than your mortgage payment for rent. Even paying $100-$200 extra each month will speed up the process of paying off your mortgage and save on some interest.
Once you can comfortably afford that, investing while having a mortgage is a safe idea. Even if we look at the interest rate, the average interest rate for a 30-year mortgage is ~6% (https://www.nerdwallet.com/mortgages/mortgage-rates). Thus, you would earn more in the stock market than you are paying on interest.
Overall, investing while in debt with a mortgage is a good idea.
Credit Card Debt
Another common form of debt in America is credit card debt. By design, it is very easy to spend too much on a credit card and need more cash to back it up. This leaves many people struggling month to month to pay it off.
To be clear, by credit card debt, I don’t mean just using a credit card. You don’t carry any debt if you spend $300 on a credit card in a month and pay the full $300 back when it’s due. You start paying interest and incur debt if you pay off less than $300 when it is due.
Credit card debt is very easy to add on to, making it not a fixed loan. If you carry $100 of debt to the next month, it’s easy to miss your payment next month by $100 again and now have $200 in total debt.
In addition, credit card debt has a >20% interest rate. This is much higher than any expected return from the stock market. So, you can’t expect your investments to outpace your interest.
Overall, you should refrain from investing while having credit card debt.
Auto Loan
Auto loans are very similar to mortgages in many ways. They involve relatively large loans, have a relatively low interest rate of around 7%, and are fixed amounts. The primary difference is the discussion of whether or not it is a living expense.
Regarding the interest rate, auto loans vary. If you purchase a new car, your interest rate could be around 5%. That makes it an easy choice to invest and get those ~10% gains to profit 5%.
However, if you are purchasing a used car, your interest rate could climb closer to 9 or 10%. This puts the interest rate on the borderline of breaking even with investing. The decision at this point becomes a little more complicated.
To let compounding work its magic over time, I lean towards it still being worth investing in the market. You may not be making great or even any gains initially, but you will pay off the auto loan in a few years. By then, you will have built up a solid portfolio, and it will be growing quickly.
The primary downside to an auto loan is based on your situation – whether or not it is a living expense. If you need a car to get to work and don’t buy a vehicle outside your budget (payments ~10% monthly income), you could argue it is necessary. This makes it more acceptable to count it as part of your budget and invest while paying it off.
However, if you can walk or bike to work, have access to cheap or free transportation such as a parent’s used car, or purchase a vehicle outside your budget, the situation flips. Investing will not be worth it until you leave that situation. At that point, you need to prioritize saving money through affordable options or aggressively paying down your loan.
Overall, auto loans are tricky, but investing while in debt with an auto loan is usu.
Student Loans
Sadly, student loans are a necessity for many people. Due to rising costs in America, 55% of public four-year students have loans. This leads many graduates to wonder whether they should invest or focus on paying off their loans.
Student loans are long-term loans, giving you ample time to pay them off as you please. They also don’t have very high interest rates. Usually, the interest rate is around 5%, giving you room to profit from investing. The loans are also fixed, so you won’t have to worry about the principal increasing out of nowhere.
The sticking point is that student loans aren’t usually a living expense. Paying off your loan isn’t contributing to your daily necessities like a mortgage or auto loan. Thus, treating it less like a bill and more like a goal to pay it off may be better.
Overall, it is a good idea to invest while in debt with student loans.
Closing Thoughts
Investing while in debt is a scary thing. Depending on the type of debt, investing is a fantastic idea to continue building wealth. I greatly advocate investing as it creates wealth in a way few other things can.
If you choose to invest while in debt, realize that market returns are never guaranteed. We could easily have a bad year that causes us to lose money instead of gaining money. Don’t depend on market returns to help pay off your debt.
Market returns take a long time. Whenever you invest but especially when you’re in debt, make sure you are prepared to lose money in the short term. It may not happen, and that would be fantastic, but you never know. Invest with the mindset that 5, 10, or 15 years from now, you will have to build substantial wealth.
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