Pay Off Debt or Invest? Think About Your Rate of Return

Andrew writes in:

My girlfriend and I bought a home last year and qualify for the First Time Homebuyer Credit. When you include my share of this, I will be getting back around $4500 in my tax refund. This is a lot of money to me and I’m trying to decide what to do with it. About half will go toward an engagement ring, but I’m torn between investing the other half or paying off my $2,000 in credit card debt. I currently have a very low APR on the credit card and can pay more than the minimum each month. As a licensed broker, I am very involved with the markets and believe I can make 10-15% a year. If I can get a higher percentage return on the investments than the APR I pay on the card, doesn’t it make more sense to invest?

In essence, Andrew is comparing two rates of return here.

First, there’s his credit card. An investment in paying off a credit card has a guaranteed rate of return – the interest rate on the card.

On the other hand, there’s the stock market. An investment in the stock market might have a higher hypothetical payoff, but it’s not guaranteed at all.

Regardless of whether the year was 2008 or 2010, paying off a 9.9% credit card will net you a 9.9% annual return on your money. Alternately, if you were able to get a 10% return on your stock investments in 2008, you were an absolute magician.

The reason that the standard advice is to pay off your high interest debts before you invest is because paying off high-interest debts is a far better investment than the stock market. Why? That rate of return is guaranteed – no stock market investment is ever guaranteed.

Here, Andrew might argue that he can invest in the stock market and return a bit better than average. That may or may not be true – we won’t argue that point here.

Even if Andrew can beat the market by 2% at any given time, his investment is still tied to the ups and downs of the stock market as a whole. In 2008, when many indexes lost 40% of their value, Andrew would have lost “just” 38%, for example.

Obviously, then, the investment Andrew is talking about is a long term investment, one that will likely pay off with a profit over a long stretch of time. If he can actually beat the market a bit, it’ll earn him a tidy return.

But that’s still not a good reason to throw money in in the short term.

Here’s what I propose, Andrew. Pay off that credit card debt, then cut up the credit cards until you can use them without accruing a balance. Then head down to your local bank and set up an automatic withdrawal from your checking account equal to the amount you were paying on the credit card debt. Channel all that money into your stock picking expertise.

If this is truly a long-term investment – and that’s when most people should invest in stocks unless they’re actively day trading – then it doesn’t matter exactly when you get into the stock market. Putting in a bunch of money now versus putting it in slowly over the next year makes little difference when you look at a fifteen year timeframe with unknown ups and downs.

Good luck.

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