PART 2: Should You Invest While Holding Debt?

Welcome to Part 2 of the Fight Fire With FIRE Investing Guide! In the previous section, we covered your emergency fund: what it is, why it’s important to have one prior to investing, how much it should be, and where to keep it. If you don’t have an emergency fund, I strongly recommend going back and reading Part 1 first. Here we are going to cover the second most important consideration prior to investing: your debt position. Let’s get started.

Debt

If there’s a second area that we Americans tend to do poorly in (aside from savings), it is without a doubt the amount of (and types of) debt that we carry. Far, far too many of us live beyond our means (spending beyond what we make), and consequentially carry debt like a millstone around our necks. Along with building an emergency fund, debt reduction ranks among your highest priorities when forming a financial plan. 

Far, far too many of us live beyond our means (spending beyond what we make), and consequentially carry debt like a millstone around our necks.

So, with regard to debt, how do you know you’re ready to invest? Here’s the simple answer: you should have no high-interest debt. None. Zilch. To understand why, we need to follow the math. According to Vanguard’s research data, the stock market has earned an average annual return of 10.3% over the last 94 years (1926-2020). Accounting for inflation, this means a real return of roughly 7.3%. For our example, let’s assume this is the return you can expect on your investments. Now, let’s fill out the picture, and say that you are thinking of investing, but currently hold $10,000 in credit card debt, with an APR (annual percentage rate) of 15%. Where is your money best served? Investing and earning 7.3%, or paying down debt with an interest rate of 15%? Does it really make sense to invest and earn that 7.3% when you are bleeding out 15% to that debt? Nope. 

Now, there is a sole exception to this advice, and this is any employer-sponsored match that may be available to you as a benefit of employment. For example, let’s say that your employer fully matches the first 4% of contributions you make to your 401k. If this amount comes to $150/paycheck, this means your employer will match it—putting in an additional $150/paycheck. You can quickly see the benefit here: for every matched dollar you contribute, this means a 100% return on investment (ROI) right off the bat, and this places it above even high-interest debt on your priority list. If your employer offers a match, make sure you are contributing enough to your plan to capture your match—always. 

Now, as I’m sure you’ve noticed, a lot depends on what I mean by “high-interest debt.” Should you consider investing (again assuming a 7.3% return) if your only debt is a personal loan with an annual interest rate of 6%? After all, 7.3% is greater than 6%, so your money would be better served investing, right? Here’s what I’ll say: These kinds of decisions are individual judgment calls, and while I can’t account for all of them, I will say this: remember that the market fluctuates, sometimes wildly. That 7.3% is not, by any means, a guaranteed return. On the other hand, unless you have a variable interest rate, the rate that you pay on your debt will remain constant (this is called a fixed interest rate). Keeping this in mind, here is my recommendation for types of debt to pay off before investing:

  1. Credit card debt (all)
  2. Personal loans (if interest rate is >5%)
  3. Student loans (if interest rate is >5%)
  4. Mortgages and auto loans are typically low-interest debt, but if the rate is >5%, consider paying it off first or refinancing to a lower rate

Okay, so you have targets on your high-interest debt sources, and you’re ready to pull the trigger. But…what is the best way to do it? Well, I’m a huge proponent of following Dave Ramsey’s “debt snowball” method when working out a debt reduction strategy—with one key twist. For those that are unfamiliar, here’s how it works:

  1. Establish a budget (if you haven’t already). Determine from this the most you can afford to put towards debt every month—work your budget to make this amount as much as you can.
  2. Sit down and write out a complete list of all your debt sources. 
  3. Mark each debt source as high-interest or low-interest (see above). 
  4. Write the current balance, minimum payment, and annual interest rate next to each debt source.

Here’s where I deviate from Dave Ramsey. He typically advises sorting your debt sources by balance—from smallest to largest—and prioritizing those with the smallest balances first. His reasoning for doing this is that getting a few “quick wins” against smaller debt sources establishes psychological momentum for the larger balances ahead. I differ from him here, and I will explain why in a moment. I want you to:

  1. Order your debt sources by interest rate—highest to lowest. Your highest interest rates will be at the top of the list, and your first targets.
  2. Here’s how it will work: Make the minimum payments on all debt sources except the one at the top of the list. From your debt budget, you will put everything remaining towards that debt source as your top priority. Go after it. If you have extra money for the month, throw it at that top priority debt. Knock it down as quickly as you can. Keep doing this every month until the top debt source is eliminated. Then you will “snowball” the amount you’d been paying to that one into the next one down on the list; keep making minimum payments on the rest. 
  3. Continue paying down your debt sources in this way until you cross the threshold into your low-interest sources. Your high-interest sources should all be eliminated! 

A quick note on why I differ from Ramsey. As I mentioned above, his reasoning for knocking down smaller balances first is psychological momentum. I, on the other hand, want you to pay as little in interest as you can while you’re paying down your debts. Paying down the debt source with the highest interest rate first ensures that you will pay as little in interest as you can. In the end, this means you pay less to creditors, and have more available for the rest of your financial plan. Depending on your interest rates, the amount saved can be substantial.  

Paying down the debt source with the highest interest rate first ensures that you will pay as little in interest as you can. In the end, this means you pay less to creditors, and have more available for the rest of your financial plan.

Putting It All Together

Now, we’ve covered these two areas independently: your emergency fund and high-interest debt. If you’re like a lot of would-be investors, however, you may be looking at a situation that needs work in both areas. For example, let’s say you have no emergency fund, and you have credit card debt totaling $10,000 with an APR of 15%; also, you’ve done a budget and determined that your monthly expenses total $3,000. How should you tackle this situation? Should you build your emergency fund first? Knock down your high-interest debt? My answer is: a combination of both. Using these numbers as an example, here’s my advice if you have work to do in both of these areas:

  1. Begin by funding your emergency fund with one month’s expenses ($3,000). While you are doing this, continue to pay the minimums on all your debt sources. 
  2. Eliminate your high-interest debt using the modified “debt snowball” approach outlined above. If, during this phase, you have to use any of your emergency fund, revert back to step 1 until your emergency fund is back to one month’s expenses.
  3. When all your high-interest debt has been eliminated, go back and fully fund the rest of your emergency fund (3-6 months’ expenses, or $9,000 to $18,000)

Leave me a comment below and let me know your strategy for tackling your high-interest debt!

Okay, so now you’ve got both covered. Fully-funded emergency fund (3-6 months’ expenses), check. No high-interest debt, check. Now what? Well, coming up next in Part 3, I’m going to introduce you to a form of investing that is both very simple and very effective. Very simple, in that you can hold a portfolio of only 2-3 funds, and manage it entirely yourself. And very effective, in that compared to other approaches, you will have an almost assured chance (think 85-90%) of a higher return at the end. 

I’m glad you’re with me. Let’s get started.

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