Over and over and over again, readers ask me some variation on this question:
I have $1,000 in my hand. I am trying to decide if I’m better off paying off part of my credit card debt or investing it. What should I do?
The thing is, my answer is almost always the same, and I thought that because it’s asked so often by email, it might be worthwhile to spell it all out in detail here because if a lot of my readers are asking, it’s probably a question that many more have, and also so that when people write to ask in the future, I can send them to this post for an answer.
First of all, this is not a question about which option is the better investment. That’s not even a question. The average credit card debt runs about 16%. The average investment earns about 8%. Treating it as cash earns nothing. Thus, the three options are pretty well graduated: paying off the credit card will net you the most “return” on your money, simply because the negative growth (for you) of your credit card balance will far exceed the positive growth of most investments.
So why even look at this question in more detail at all? The problem is that most people look at investments based solely on the expected rate of return – and that’s a mistake. With these figures, there’s a major additional risk factor that hasn’t even been mentioned to this point, one that could potentially make the investment option seem better than the credit card payoff. What is it? The person in debt is the risk factor.
In the past, I discussed how human nature is a massive investment risk, and this is perhaps the most clear cut example of what I’m talking about. Our friend here has an outstanding credit card balance in the thousands. This means at some point in the recent past, our friend has spent significantly more money than he/she has available. This is an investment risk.
Let’s say you have two people, one of whom has no credit card balance and one of whom has a $5,000 credit card balance. You can give one of them a $100 bill, but you must give it to the one who will spend it more responsibly. Who would you give it to? To me, the answer is clear: the person with no credit card balance is much more likely to be a responsible spender.
So, let’s roll this back into the original question. There is a significant risk that if the person uses the money to pay down the card, he/she will charge the card up again. This basically makes the credit card payment no different than cash in hand – either way, the money is spent on material goods. Thus, putting the money into an investment that’s difficult to touch, like a Roth IRA, may be a better choice.
What’s the best solution? Cut up the credit card and delete the number from any online accounts, then use the cash to pay down the balance. You’re eliminating (or at least strongly reducing) the human risk from the best investment option available to you, and thus in the long run you’ll reap the rewards by having significantly lower interest payments.
This overall philosophy is true no matter what the debt, unless the debt is a very low interest one. If that is the case, the investment might be the best option of all no matter what.