A common question is whether to use leftover money to get out of debt or invest. The idea is that if the return you get in the stock market is greater than the debt’s interest payment, you should do it. I am here to tell you, DON’T DO IT. I will go over reasons why paying off debt is better than investing. I’m a big fan of using debt to your advantage if it makes sense. However, this isn’t one of those times where it makes sense. If you’re in a significant amount of debt, it means that you’re in a hole. Doing something that gets you out of the hole is the necessary action you need to take. Investing can put you in a bigger hole.
Yes, if you really know what you’re doing, you can get out of that hole faster than scheduled. However, be brutally honest. Do you really know what you’re doing or is it that you are confident that you know what you’re doing? When you invest in a stock simulation (I recommend Investopedia’s) do you end up making money or losing it over a period of time?
You might say “I didn’t take the simulation seriously because it’s not real money.” Or “it will be different when I actually have real money to invest.” I understand the difference. You will care more if your hard earned money was on the line. However, The difference is not significant because caring more will not make you more money in the stock market.
“I Know I Can Make More Money Investing”
A friend of mine recently asked me to help him open a Robinhood account. Let’s call him Mario. I was happy to help him out because he’s a good college buddy of mine. He used to teach me how to use technical analysis for the stock market. After learning it, I’m not convinced. I don’t recommend anyone use technical analysis to invest because those traders are fantastic at losing money. But I digress.
From our conversations during college, Mario told me that he financed a part of his degree with debt. An almost 5 figure debt. He has a high paying job currently so it’s not a problem (he makes $7,500 a year more than me). However, he’s at his last $5000 of student loan debt and he wants to use funds to invest rather than get out of debt.
He’s getting tired of using money to do something he’s not happy with (paying off debt) instead of doing something he’s passionate about (investing in the stock market). I understand that it’s good to invest time and energy to something that gives joy. But losing money should never be joyful.
Why do I say that he will lose money? It’s not that I think he’s not smart. He’s very smart with great ethics. It’s that during college, he’s dreamed about investing in his parent’s basement right after college and making money that way. We used to talk about how great of a life it would to day trade.
However, from the years that he’s been investing, he’d lose money. I don’t know the specifics but he shut his investing operations down. He used to stay up all night watching the Forex markets in hopes to make money. I can’t imagine he would shut it down if he was making money.
Investing Requires Certain Characteristics
He’s not patient and he’s looking for instant returns. I remember talking to him one day and he was saying how he’s looking to get 100% returns in a week. Yes, it is very possible because he was invested in forex, where the volatility is ludicrous. It’s also very possible to lose 100% in a matter of minutes.
He started investing in stocks then he didn’t do so well so instead of mastering one thing very well, he started branching out to options. He didn’t do so well either so he branched out to foreign exchange. You know where the story is going. He stopped investing because for 1) he was in debt and for 2) he was using his partner’s money to invest with.
The stock market has given out overnight millionaires before (the tech bubble where 10x returns in a month were the norm). It has also given out overnight bankruptcies before (think of the tech bubble bursting and the financial crisis of ’07).
These are black swan events where if you had prepared for them by taking advantage of index funds that give benefits of diversification and value, you wold have come out in a stronger position than before the crash. I’m a little worried at the lofty valuations set in place and want a bear market to come soon. It’s where investors make most of their money in.
Why Get Out of Debt? Instant Returns
I would much rather get out of debt surely than look for the easy way out. Furthermore, if you use money to pay down your debt, you get Instant and Guaranteed Returns. Mario’s rebuttal was that he isn’t getting a return because he’s PAYING debt, but that’s the wrong way to think. The return you get is the interest that you pay to get out of debt. In this case, he pays a 4% interest on his $5,000 student loan.
If he and I each had $5000 and I used it to get out of debt, I would end up with $0 by the end of the year. He would end up with $-200. $200 is a 4% return on $5000. I get a 4% return just by paying down debt. And this return? Risk free, baby! I would take a risk free 4% return ALL. DAY. LONG. The 1-year T-bill rate is at .57% right now. Almost 8x times better than the normal risk free rate, can’t complain about that!
The Average Investor Loses Money
The average investor loses money in the stock market. According to that article, 70% of investors lost money in 2015. The odds are against Mario to make money. Especially with his investing style of wanting to get returns, fast. When you’re working hard to get out of debt and dig yourself out of the hole, it’s not good to take on bad risk.
Bad risk is when you understand the odds are against you but you take it anyway. If you ALWAYS make decisions that will give you positive results more often than not, there’s no way you will lose over the long-term. In the short term, you might lose but if you simulate that decision over the long term, you will come out ahead.
Personal finance websites preach index funds because they work. The stock market, over the long term, provided positive returns. An average return of 7% or so. My 401k is 90% invested in the S&P 500 and 10% in a bond index fund. The 5 figure cash balance I racked up is in my trading account because I can afford to take risks when I’m young. My retirement account will ensure that I never will be in financial trouble because I save 55% of my money into it.
Mitigate Risk, Look for Margin of Safety
I’m protected to the point where in 1-2 years, I won’t ever worry about money. Therefore, I can afford to take a lot of risk in my trading account and I fully intend on taking advantage of the risks that I’m allowed to take. If I lose 100% of my trading account, I still won’t need to worry about money. My risk is so mitigated to the point where I can sleep very soundly at night. I have no debt, my trading account funds is enough to last me for the next 2 years, and I have steady income coming in from my job.
I worked hard to get to this point, however. Afternoons were spent working and summers were spent working in internships. I sacrificed a couple years working hard so that I could enjoy decades of stress-free life. The investment was well worth it. Now, my risk is low enough that I’m able to make a few mistakes going forward without huge repercussions. Investing while being in debt is taking on extra risk, which isn’t smart. In the short-term it could work out in your favor but in the long term, it could come out bad.
Readers, would you rather get out of debt or invest? Do you have successful stories of getting out of debt through investing? Let me know in the comments below!
My goal is to enable your success in personal finance so that you can realize the American dream. The first step is starting today!
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