Is saving money and then investing it really that important for your financial health?
If you’re giving me a “Well, duh” look right now, I don’t blame you. Of course it is. We all know that.
But what if you have debt? Does it still make sense to automatically funnel dollars into a savings account, a tactic I recommended in Part 3 of my series on How to Save Money? Shouldn’t you pay off the debt first? Do both?
This is an important set of questions given that debt is a big problem at the moment. Consider the following:
Debt is a real issue for a lot of people. So what to do if you know you should be saving money, but there’s debt in your financial picture? Here’s a quick guide.
If we were purely rational beings, we would choose the path that yields the most favorable outcomes in terms of our dollars. This boils down to sorting out the opportunity cost, a concept from economics that refers to the potential gains or benefits you give up when you select one option over another.
An example: Let’s say you spent much less money than you made this month, leaving you with $500 floating around your bank account.
PRO: You’ve grown your savings and, therefore, your net worth. This is good. These funds could be used as part of your Emergency Fund if you don’t already have one in place.
CON: Your money is only earning between 1% and 2% if you’re lucky (or 2.3% if you have an EQBank High Interest Savings account here in Canada). By parking money here, you’re not earning enough interest to cover the effects of inflation – the annual erosion of a dollar’s buying power. Again, if you’re building an Emergency Fund, then the money has an important job to do – be there for you when life happens. If you already have an Emergency Fund and this extra money is simply hanging out in a savings account, it’s slacking off. It should be working a lot harder for you.
PRO: If you use a research-based, passive investing approach using low-cost index funds, then your money will provide you with market returns minus the fund costs.
What are those market returns? The average annual return of the S&P 500 since 1957 is roughly 8%, for example. That’s much better than a savings account! That said, most people add bonds to the mix in order to mitigate risk, and bond returns are typically lower than those from stocks. A rule of thumb that one financial advisor suggested to me is to assume that your portfolio, as a whole, will grow roughly 5% – a conservative estimate – if you use a low-cost, indexing approach with built-in diversification.
CON: Stock market returns are not guaranteed. Historically, stocks have done well over time despite the sometimes large swings up and down in value. What we can’t say, however, is when the highs and lows will happen. If you take your extra cash and invest it today, the market may go through a downturn tomorrow, one which could last for several years. Your returns would obviously be poor during that time. You’ll be just fine over the long haul, but in the short term it could be a rough ride. The trick with this route is to ensure that you stick to your plan and don’t buy or sell on emotion.
PRO: Every time you pay down your debt, you have an immediate return equal to the rate of interest you’re paying on that debt. For example, if you use the extra money to make a payment on your Mastercard, you would immediately save 18% – 30% in interest on that amount. The debt is no longer bleeding out interest fees at a double-digit rate. That’s a guaranteed return that you cannot match through any legitimate investments that I know of! No wonder I refer to credit card debt as corrosive debt.
CON: But what if your debt has a lower interest rate than the average annual returns to be found in the stock market using index funds? Like, say, a mortgage rate of 3.2% or a Line of Credit (LOC) at 4.5%? Then I would argue that investing will yield a better outcome, over time, than paying off this debt. If you pay down your low-cost mortgage, you’re potentially leaving a lot of growth on the table, which means it will take longer for you to hit your “happy retirement” or financial freedom number.
If your debt is more expensive than the expected returns for your investments, pay off the debt.
If they’re the same – i.e. LOC at 5% interest and project returns for your investments = 5% – then go with the sure thing and pay down the debt.
If the cost of the debt is lower than the expected returns from investments, build up your investment accounts.
Only send the funds to a savings account when you have no debt and a) you’re building an Emergency Fund; b) you’re saving up for a specific purchase or event; or c) the funds are being temporarily held before being invested.
The above is the mathematically sensible thing to do. There’s just one problem – we are not mathematical creatures; we are creatures of psychology, which means we are irrational. Me, you, all of us.
Strategies that make perfect mathematical sense and get us the results we seek in the fastest way possible sometimes fail to inspire us. In other words, we don’t always look at a pile of debt and think, “I have an extra $500 this month to throw at my high-interest debt. This is the best use of my money right now because it will save me 20% in interest costs forever more. This rocks!”
Instead, we may look at that massive pile of debt and think, “What’s the point? Five hundred bucks isn’t going to make a big difference. I’m tired of having my extra money disappear into what feels like a black hole.” And we spend it.
One of my readers put it this way:
I’m actually finding the psychology of money for me personally is that I have to invest in order to take steps to pay off debt. I have to see something going into the plus column to feel like it’s worth it to address the minus column, even though it would be more financially beneficial in terms of interest rates to just hit the minuses with everything I’ve got.
This makes perfect sense to me. Here’s why: We don’t see the interest we are not charged, but we do see an investment account increasing in value. One benefit – the larger one – is invisible, while the other is highly visible. It’s hard to keep going when the improvements to your financial situation are slow and virtually imperceptible until you reach a tipping point.
Debt repayment can feel like a slog, a black hole that never seems to be satisfied. It’s not until you’ve put in an effort over time that you realize you have so much more money in your account because it’s not being siphoned off to service debt.
If this is something you’re experiencing, try adopting my reader’s approach of investing some of your extra money while also paying down debt. If your debt is corrosive (i.e. credit card debt or high-cost lines of credit), then send the bulk of your cash to the debt and keep the smaller share for the investment account.
Whatever keeps you in the game, moving forward is the right strategy for you. I’d rather see someone take this approach than give up altogether.
Pay off debt or invest, the result is the same: a higher net worth. That, my friends, is a beautiful thing.