Card Rebate

Although it may seem confusing at first glance, it should come as no surprise why financial advisors encourage you to start savings when you have a pile of debt. Why do they advise this way? Because financial advisors are commissioned salespeople. If they do not sell you their product (investments) they do not get paid.

Okay, the power of compounding is certainly a valid argument that advisors will make. However, this argument is invalidated if you carry $22,100 in debt like the average American and your income hovers around the median. In other words, a few bucks in credit payments is different than struggling with payments and investing at the same time.

One way to see whether it makes more sense to invest now or start later (after all of your debt has been repaid) is to measure your Cash Dilution Rate. What this rate tells us is how much we lose to our creditors for every $100 we earn. The higher your Cash Dilution Rate, the more it makes sense to repay your debt before committing to a true investment program.

Let’s look at this a little closer. Consider an individual who earns $2,000 in after-tax dollars. With the average American debt of $22,100 and an average rate of 14.5%, this individual’s Cash Dilution Rate rings in at 13.35%. This person keeps only $1,732.86 of her original, after-tax $2,000.

One way to understand the severity of this situation is to weigh the $267.14 in monthly credit costs against how much can be invested on a monthly basis. For example, investing an additional $250 per month reduced the amount this individual keeps every month even further to less than $1,500 ($2,000 – ($267.14 + 250.00)).

Now, if this individual had no debt at all, the $250 might make perfect sense as she is already spending more than that on her debt payments. So, what impact does paying debt and investing have on her long-term savings? Of course, there is no easy answer because there are two things we need to consider.

In the first case, this investor might find that an additional $250 per month to invest is, in fact, not much of a sacrifice. If this is the case, then that additional $250 should still go toward repaying debt (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). This would reduce the debt even faster, from a little more than 57 months until full repayment without using the extra $250, to a little less than 35 months if she uses that $250 to repay the debt. Once all of the debt is repaid, the $250 + $267.14 can be invested for a total investment value of $517.14 per month.

Another factor weigh is timing. If our investor has only 15 years left, as of today, that means she loses 3 years of potential compounding. The impact will this have on her savings is minimal. By deferring her $250/month savings and repaying debt instead and then, in three years investing $517.14 per month instead, this individual will have saved $38,283 more over 12 years (remember, she lost 3 years by repaying that debt first) assuming the rate of return is constant and she can still invest $250 plus the $267.14 she saves in credit repayments. More importantly, after 3 years, she will be debt-free, which automatically puts her in a better position to tackle unplanned financial hardships.

What might happen after repaying her debt, however, is that she decides that $250 was too aggressive in the first place. Instead, she will invest only $125 of that amount and spend the remaining $125 on something she loves, something like shoes. Even though she is enjoying her life a little more with more shoes than she ever needs, she will still be investing $392.14 ($125 plus the $267.14 that she used to pay toward debt). What impact will this have? Well, none. Even though she is spending less (392.14 versus 517.14) and is starting 3 years later, she actually comes out ahead to the tune of $7,167. Plus, she will be debt free (yes, there is a theme to this importance of living a debt-free lifestyle).

As you might have guessed, debt repayment should almost always take priority over an investment program. This seems counterintuitive to a lot of what our advisors tell us, but in most cases we can repay debt faster and thereby invest more, if our after-tax dollars are used more wisely. In some cases, you should consider an investment strategy in conjunction with a repayment plan, but those situations are rare.