Should I pay off my credit card in full or invest?
A system for deciding to pay off debt or invest:
Last year, the average American household had over $96,000 in debt—made up of credit cards, student loans, car loans and leases, and more.
So if you’re paying down debt, you're not alone.
For many, it can be difficult to get debt paid off over time. As lifestyle expenses increase it can often be harder to save or invest at the same rate you did before.
But at Factora we teach that investing is the key to building wealth, creating more financial flexibility, and retiring well before you’re 65.
How do you decide where to focus first? Do you pay off all of your debt or do you start prioritizing some money towards investing?
While we’d love to give you a clear answer one way or the other, the truth is it depends.
First things first: let’s talk about interest rates:
The interest rate on your debt is the amount the lender charges you to borrow their money. It’s calculated as a percentage of the principal (the amount loaned). The interest rate on a loan is typically noted on an annual basis known as the annual percentage rate or APR.
Interest rates can vary pretty widely from around 3% for student loans to 16-24% for credit card loans.
On the other hand, the average annual return of the stock market (AKA how much money you earn) over the last hundred years has been 10% per year.
So what does that mean?
If the interest rate on your debt is likely to cost you more than you'd earn from the stock market (if the APR is 10% or above), then you should focus on paying that off entirely as quickly as possible.
If the interest rate on your debt is likely to cost you less than you'd earn from the stock market, then you should pay the minimum and prioritize putting additional money into your emergency fund or your investments.
Here’s an example of what happens when you charge $10,000 to a credit card with a 20% annual percentage rate vs when you invest that same monthly payment into the stock market.
The minimum monthly payments in this example are $193, meaning that after ten years of paying the minimum on that card, you would have paid them $23K for that initial $10,000 worth of charges and have an account balance of $0.
Now, let's say you didn't have those high-interest credit card debt payments and instead chose to invest that same $193 amount into an account with an 8% return (the average annual return of the stock market over the last 100 years has been 10%—assuming an 8% return helps account for inflation).
In ten years, you would have paid yourself $23,000 and accrued $12,500 in investment returns—giving you an account balance of $35,500!
This is why the sooner you can get the power of compounding working for you rather than against you, the better.
But wait…there’s one more thing.
In order to prevent yourself from going further into debt, it’s crucial to have an emergency fund so you can pay off any unexpected bills in cash, rather than adding them to your credit card.
Introducing the Factora Debt Quadrant. Let's break this down:
The pink section: If you have high-interest debt (over 7-10%) and no emergency fund, focus on getting your emergency fund up to at least 50% is vital before paying debt down beyond the minimum.
The brown section: If you have high-interest debt and at least 50% of your emergency fund filled, start by focusing on paying off your debt. Then finish filling your emergency fund all the way before focusing on investing.
The green section: If you only have low-interest debt (less than 7%), continue paying your minimums while filling your emergency fund to 100% and then start investing!
At the end of the day, it’s up to you to determine which strategy makes the most sense for you based on your current financial situation and risk tolerance.
Looking ahead
Eliminating high-interest debt is one step of many in protecting your wealth and building towards financial flexibility and ultimately, financial freedom.
Next week, we'll talk about maintaining a values-based spending system and how this supports your ability to build wealth by helping you avoid purchases and liabilities that don't add value to your life.
Don't forget
Get even more insights with our weekly podcast, Coffee & Coin, hosted by our Founder & CEO, Allegra Moet Brantly.
Ready to dive deeper? The Wealth Circle is our live online course and community dedicated to helping women invest confidently and reach financial freedom.