The Waiting Game: Unraveling The Timeline Of Investment Returns

Investing and paying off debt are both important financial goals. The question of which to prioritise can be tricky, as there are compelling arguments for both. On the one hand, investing money can be a way to make your money work for you, with the potential for high returns. On the other hand, paying off debt can reduce financial strain and improve your credit score.

Compounding interest

The magic of compounding helps a sum of money grow faster than if simple interest were calculated on the principal alone. The greater the number of compounding periods, the greater the compound interest growth. For example, a $100,000 deposit receiving 5% simple annual interest would earn $50,000 in total interest over 10 years. However, if that same deposit had a monthly compound interest rate of 5%, the interest would add up to about $64,700.

Compounding periods refer to the time intervals between when interest is added to an account. Interest can be compounded annually, semi-annually, quarterly, monthly, daily, continuously, or on any other basis. The higher the number of compounding periods, the larger the effect of compounding. For example, a $10,000 loan at a 5% interest rate, compounded annually over 3 years, would result in $1,576.25 in interest.

The Rule of 72 is a simple way to estimate how long it will take for your money to double in value due to compound interest. By dividing 72 by your rate of return, you can determine the number of years it will take for your money to double. For instance, if you have $100 earning a 4% return, it will take 18 years to grow to $200 (72 / 4 = 18).

Tax benefits of investing

Taxes can take a significant chunk out of your investment returns, so it's important to consider tax-efficient investing to minimise your tax burden and maximise your bottom line. Here are some tax benefits to consider when investing:

Choose Tax-Efficient Accounts

The type of account you hold your investments in can have a significant impact on your tax liability. There are two main types of investment accounts: taxable accounts and tax-advantaged accounts. Taxable accounts, such as brokerage accounts, don't offer any tax benefits, but they provide more flexibility as you can withdraw your money at any time without penalties. On the other hand, tax-advantaged accounts like IRAs and 401(k)s offer tax benefits but have annual contribution limits and restrictions on withdrawals.

Identify Tax-Efficient Investments

Some investments are naturally more tax-efficient than others. For example, municipal bonds are often exempt from federal, state, and local taxes, making them a good choice for taxable accounts. Similarly, Treasury bonds are exempt from state and local income taxes. In contrast, corporate bonds don't have any tax-free provisions and are better held in tax-advantaged accounts.

Employ Tax-Efficient Strategies

There are several strategies you can use to reduce your tax burden. One is to manage your capital gains by holding investments for more than a year to qualify for long-term capital gains tax rates, which are typically lower than short-term capital gains tax rates. Additionally, you can use tax-loss harvesting to offset capital gains with losses from other investments. You can also consider charitable giving as a way to reduce your taxable income while avoiding taxes on capital gains.

Create Tax Diversification and Flexibility

Diversifying your investments across accounts with different tax treatments can give you more flexibility in managing your taxes during retirement. For example, you can hold tax-free municipal bond income and qualified dividends in taxable accounts, while holding tax-free Roth accounts for long-term growth. This way, you can assess your tax situation each year and make strategic withdrawals to minimise your tax burden.

Investing vs debt repayment

Investing and paying off debt are both sensible uses of extra cash. However, it can be challenging to decide which to prioritise. The best option depends on your financial situation, risk tolerance, and the interest rates of your debt. Here is a detailed look at investing vs debt repayment to help guide your decision-making.

The Case for Investing

If you can earn more interest on your money by investing than the interest you are paying on your debts, then investing may be the better option. For example, if you have a mortgage with a 5% interest rate and can invest in a stock market index fund returning 10% annually, investing is likely the wiser choice.

Another factor to consider is your risk tolerance. Investments can be volatile, with potential for gains and losses over time. If you are comfortable with this risk and the potential for market fluctuations, investing may be a good option.

The Case for Paying Down Debt

There are several arguments for prioritising debt repayment over investing. Firstly, if your debt carries a high-interest rate, particularly credit card debt, paying it off can provide a better return on your money than most investments. The average credit card interest rate is high, and few investments can match this rate of return.

Secondly, consider your credit score. Paying off debt, especially credit cards, can improve your credit score, which is essential when applying for future loans, such as mortgages or car loans. A low credit score may result in higher interest rates or difficulty securing loans.

Additionally, there is a mental and emotional element to paying down debt. Eliminating debt can provide a sense of relief and reduce financial stress. Waiting to pay off debt means carrying that burden longer and accumulating more interest charges.

The Case for Doing Both

Prioritising debt repayment over investing, or vice versa, is not always a binary decision. It is possible to do both simultaneously. Creating a detailed budget that outlines your income, expenses, and financial goals can help you allocate your money effectively.

Additionally, you can focus on building an emergency fund while also paying down debt. A money market mutual fund is a good option for an emergency fund as it is low-risk and highly liquid.

Tips for Managing Debt and Investing

When deciding between paying off debt or investing, consider seeking advice from a financial advisor. They can help you develop an investment strategy tailored to your age, risk tolerance, and overall goals. It is also essential to compare different investment options, such as online brokerage accounts, and take advantage of employer-matched retirement plans, such as a 401(k).

Paying off debt first

When it comes to investing, it's important to consider your overall financial situation and long-term goals. This includes thinking about any debts you have and how they fit into your investment strategy.

There are a few strategies to consider when paying off debt. One approach is to focus on the debt with the highest interest rate. This strategy, known as the avalanche method, involves making minimum payments on all debts while putting extra money towards the debt with the highest interest rate. This can save you money in interest payments over time. However, this method may not be the most motivating, especially if the debt with the highest interest rate also has a large balance, as it can take a while to see progress.

Another strategy is to focus on paying off the smallest debts first. This approach is known as the snowball method and can be highly motivating. By paying off smaller debts first, you can quickly gain a sense of achievement and build momentum. This can help you stay on track and motivated to tackle larger debts. However, this method may result in paying more interest overall.

Alternatively, you could consider consolidating your debt. This involves combining multiple debts into a single loan with a potentially lower interest rate. This strategy can simplify your finances and may help you pay off debt faster. However, there may be upfront costs, and it's important to ensure you don't end up with a longer repayment term that keeps you in debt for longer.

When deciding which strategy to use, it's essential to consider your specific financial situation, including your income, expenses, and debt types. Creating a budget and sticking to it is crucial to ensure you can make consistent payments towards your debts. Additionally, evaluating your spending habits can help you identify areas where you can cut back and free up more money to put towards debt repayment.

In conclusion, paying off debt first can be a wise financial decision before investing. It can improve your cash flow, boost your credit score, and provide psychological benefits. The right strategy depends on your individual circumstances, but by creating a plan and staying disciplined, you can work towards becoming debt-free and achieving your investment goals.

The case for doing both

While investing and paying off debt are seemingly at odds with each other, there are ways to do both. This approach can be beneficial as it allows you to reduce your debt while also taking advantage of the potential returns from investing. Here are some strategies to achieve both goals simultaneously:

Create an Emergency Fund

If you don't already have an emergency fund, consider using a portion of your money to build one. This fund can provide financial security in case of unexpected expenses or losses in income. A good place to keep your emergency fund is in a low-risk and highly liquid investment vehicle, such as a money market mutual fund, which offers easy access to your money when needed.

Prioritize High-Interest Debt

When paying off debt, focus on the ones with the highest interest rates first. For example, credit card debt often carries high interest rates, and paying it off can provide a better return on your money than many investments. By tackling these debts first, you can save money on interest and accelerate your debt repayment.

Take Advantage of Refinancing and Debt Consolidation

Refinancing your existing loans or consolidating multiple debts into a single loan can help lower your interest rates and reduce your monthly payments. Student loans, mortgages, and credit card balances can often be refinanced or consolidated to make them more manageable. This can free up extra money that can be allocated towards investing.

Maximize Employer Matching on Retirement Accounts

If your employer offers a retirement plan, such as a 401(k), and provides matching contributions, be sure to contribute enough to take full advantage of this benefit. This is essentially "free money" that can boost your retirement savings. These contributions are typically made with pre-tax dollars, providing additional tax advantages.

Choose the Right Investments

When investing, opt for vehicles that offer higher potential returns than the interest rates on your debts. For example, investing in stocks, bonds, or mutual funds can provide higher returns over time compared to the interest rates on a mortgage or student loan. However, consider your risk tolerance and investment horizon when making investment decisions.

By implementing these strategies, you can work towards both paying off debt and investing simultaneously. This approach can help you strike a balance between financial security and taking advantage of opportunities to grow your wealth.

Frequently asked questions