Just when we were becoming used to entrepreneurs telling us how they had leveraged the power of debt to boost their income and become millionaires by the age of 30, comes along billionaire investor Mark Cuban who says just the opposite. In an interview given to Kitco News, he said that the safest investment anybody could make is to pay off debt. He went on to say that if you repay a student loan carrying an interest rate of seven percent, it is as if you were earning seven percent and also saving yourself the trouble of identifying an investment opportunity and that too one that was completely risk-free.
Surprising as it may seem, one does acknowledge that there seems to be more than a grain of truth in this investment philosophy. However, since each person’s financial profile is different, the question of whether it is better to invest or to repay debt needs closer examination.
Debt Is Just Like Investing but In Reverse
The most important thing, that a wannabe millionaire should note about investing and debt, is that they are quite similar to each other; the very same principles that make investing so vital also makes debt repayment similarly important. The rate of interest applicable to loan products is essentially a mirror image of the return that can be made on investments. In fact, if you take a close look at how investments work, you will realize that investing is just a process of lending out your money to others for a promise of return; typically, on debt that is interest and on others, it can assume the contours of capital appreciation and dividends. Not many people realize it, that as satisfying it is to see your money growing in properly-made investments, interest being paid out actually is responsible for making your net worth diminish and making your first million more difficult to attain.
Every Debt Is Different
Even though it is evident that debt acts only to whittle away your net worth due to the need for making regular interest payments, it is imperative to note that different types of loans act in different ways. Some loans can have extremely attractive terms while some can be prohibitively costly. For example, while a payday loan even though very handy to access, it can get you caught in a debt trap from which, it can be difficult to escape. A 30-year mortgage carrying a fixed rate of interest can be quite easy to manage and be beneficial to creating net worth with some amount of planning. It is extremely important for borrowers to know what type of debt they have and how exactly are they impacting on your financial health. Visit nationaldebtreliefprograms.com to learn more about the different kinds of debt.
The Prime Factor Is the Rate of Interest
The most important factor that governs the way you should allocate funds is the rate of interest. It needs to be appreciated that for loans of the same amount, the one with the higher APR should be the target of your repayment before you make any other fund allocation beyond your essential expenses. According to https://www.entrepreneur.com, as of August 2018, the average APR of credit cards in America is a mammoth 14.38%, which is far more than what you can expect as a return on any of your investments. If you are carrying credit card debt, it invariably makes sense to repay it before you consider using your money to make any investment.
One of the top reasons, why credit card debt snowballs are that the interest rate is compounded, that is you pay interest on interest unless you make continual repayments. The effect of compounding of the interest makes credit card debt difficult to get rid of if you are making only the minimum payment every month. Similarly, the compounding effect comes into play but in reverse when you invest in stocks with prices rising in an ideal market situation.
Know How Many Risks You Can Tolerate
No discussion regarding debt, investment, and returns are ever complete without the analysis of risk tolerance. Safety of investments is not an absolute term and differs from one person to another; for someone who is very conservative regarding personal finance concentrating on paying off debt can be quite important. For others, who are not so risk-averse, borrowing money to make investments can be well worth the risks involved. In fact, it is quite common for people, businesses, and institutions to take on debt for the purpose of making investments after having estimated that their return would be more than the cost of borrowing.
The Cost of Debt Is Fixed but Returns from Investments Are Not
A crucial aspect of risk analysis is that typically the cost of debt is known and fixed while the return on investment is not. Some people might take the S&P 500’s historical returns of 10% as a benchmark and assume that it is better to invest than pay off debt as long as the APR is below 10%. However, the estimate does not take into account the ground level chaos that can result in wild swings in the stock market where returns can easily slide into the red in some years. Even if you were to buy fixed return bonds, there is no guarantee that the issuer will not default at the time of redemption. Another layer of complication is added if the interest rate is variable. Therefore, the assumption that the cost of debt will always be more than returns from investment does not always hold good.
Regrettably, there is no magic formula that can be applied to find out whether paying off a debt over making investments is a better strategy for becoming a millionaire. It does make sense to pay off a credit card outstanding than making investments in the stock market but paying off a mortgage early and missing out on your 401(k) contributions can be foolhardy. While generally speaking paying off debt does seem to be more sensible, it still depends on your specific financial circumstances so be sure to do proper analysis before committing yourself.