The Power Of Paying Off Debt: Why It's A Smart Investment

Investing in paying off debt is a good idea because it helps build your net worth. It can also be a source of significant stress and anxiety relief.

Paying off debt first is a good idea if you have high-interest debt, especially credit card debt, which often hovers around 20% interest. If you fail to save or invest during this time period, you may have a net worth of zero when you eventually become debt-free.

However, investing for retirement first is also a good idea because it allows you to take advantage of compounding interest. The longer you invest, the more time your money has to compound.

A hybrid approach that balances paying off debt and investing is often recommended by experts. This approach allows you to make progress toward short-term and long-term financial goals and gives you more flexibility to adjust your strategy as your financial situation changes.

Paying off debt improves your credit score

Paying off debt can improve your credit score, but it's not always the case. There are several factors that influence your credit score, and paying off debt can sometimes cause a temporary dip before it bounces back. However, in the long run, paying off debt is likely to have a positive impact on your credit score. Here's how:

Credit Utilization Ratio

Your credit utilization ratio is a significant factor in determining your credit score. It measures the amount of credit you're currently using compared to your total available credit limit. A lower ratio is better for your credit score, and ideally, you want to keep your credit utilization below 30%. When you pay off a credit card, especially one with a high balance, you reduce the amount of credit you're using, which can improve your credit utilization ratio and boost your credit score.

High-Interest Debt

High-interest credit card debt can be detrimental to your financial health. Credit cards often have very high-interest rates, which can make it challenging to get out of debt. By paying off these high-interest debts, you can save money on interest and improve your overall financial situation. This can also help your credit score by reducing the risk of missed or late payments, which can negatively impact your score.

Peace of Mind

While this isn't a direct factor in your credit score calculation, paying off debt can improve your overall financial wellness and peace of mind. Debt can cause stress and anxiety, keeping you awake at night. By paying off your debts, you free yourself from this burden and gain a sense of financial freedom. This can lead to better decision-making and a more positive outlook on your financial journey.

Long-Term Benefits

Paying off debt, especially high-interest credit card debt, can have long-term benefits for your financial health. It demonstrates your ability to manage your finances effectively and makes you a more attractive candidate for future lending. Lenders will view you as a lower-risk borrower, which can lead to better loan terms and interest rates in the future. This can be especially important when applying for significant loans, such as a mortgage or car loan.

Access to Better Opportunities

A good credit score can open doors to better financial opportunities. It can help you qualify for lower interest rates on loans, gain approval for rental properties, and even impact your job prospects. Some employers review credit reports as part of their hiring process, and a good credit score can indicate financial responsibility and stability.

In summary, while there may be temporary fluctuations in your credit score after paying off debt, the long-term benefits are significant. Paying off debt demonstrates financial responsibility and improves your overall financial health. It's important to remember that everyone's financial situation is unique, and you should consider seeking personalized advice from a financial advisor to make the best decisions for your specific circumstances.

Investing early benefits from compounding interest

Investing early has several benefits, and one of the most important is the power of compounding interest. Compounding interest is interest calculated not only on the initial principal amount but also on the interest accumulated from previous periods. In other words, it is earning (or owing) interest on interest.

The power of compounding helps a sum of money grow faster than if simple interest were calculated on the principal alone. The higher the number of compounding periods, the greater the compound interest growth will be. For savings and investments, compound interest is beneficial as it multiplies your money at an accelerated rate.

The longer the time horizon for investing, the more wealth it will generate in the future. This is why starting to invest at a younger age is advantageous. The two key ingredients for compounding to be effective are the reinvestment of earnings and time. The more time your money is invested, the more it will grow.

For example, let's say you start saving $100 a month at age 20, earning an average of 4% annually, compounded monthly across 40 years. By age 65, you will have earned $151,550, with a principal investment of just $54,100. On the other hand, if you start investing at age 50, investing $5,000 initially, and then $500 monthly for 15 years, also with a 4% average monthly compounded return, by age 65, you will have earned only $132,147, with a principal investment of $95,000.

Another example illustrates the power of investing early. Two 25-year-olds have the same goal of retiring at age 60 but differ in their savings and investment approach. The early saver invested $5,000 a year for 10 years, from age 25 to 35. At age 60, her portfolio value was just over $615,000 with a total investment of $55,000. The "wait and save" person decided to save later, investing $5,000 a year for 25 years, from age 35 to 60. At age 60, he accumulated just over $430,000 with a total investment of $130,000. Even though the latter saver invested more than double the amount of money, he ended up with $183,000 less at age 60.

Therefore, investing early and taking advantage of compounding interest can significantly increase your wealth over time.

Investing is a good option if you can earn more interest than your debt costs

If you can earn more interest on your money by investing it than your debts are costing you, then it makes sense to invest. For example, if you have a mortgage with an interest rate of 5% and a stock market index fund that is returning 10% a year, you’ll come out ahead by investing your extra cash in the index fund.

On the other hand, if you have credit card debt at 20%, you would be better off putting your extra cash toward paying that debt rather than investing it. Credit card debt is particularly important to focus on, as it tends to have high-interest rates. The average interest rate on credit cards in April 2024 was 24.37%.

Another factor to consider is your risk tolerance. If you are comfortable taking the gamble that your investments will fluctuate with the markets, then you are a better candidate for investing than someone who would worry about the market.

If you can earn more interest on your investments than you are paying on your debts, investing may be a good option. However, it is important to consider the volatility of investments and your own risk tolerance when making this decision.

Paying off debt improves your cash flow

Another way that paying off debt improves your cash flow is by reducing your debt-to-income ratio. Lenders use this ratio to determine your ability to take on new debt. By paying off existing debt, you may qualify for larger loans or better terms, giving you more financial flexibility.

Furthermore, paying off debt can provide peace of mind and improve your psychological well-being. This can lead to better financial decision-making and a reduced tendency to make impulsive or risky choices. It can also help you sleep better at night, knowing that you have more financial flexibility and are not as burdened by debt.

When deciding whether to pay off debt or invest, it's important to consider the interest rates on your debt and your expected investment returns. If you have high-interest debt, such as credit card debt, it often makes more sense to focus on paying that off first, as it can be costly and challenging to eliminate. On the other hand, if you have low-interest debt and expect to earn higher returns on your investments, investing may be a more attractive option.

It's also crucial to build an emergency fund before focusing solely on debt repayment. This will help you avoid taking on more debt in the future if unexpected expenses arise. By improving your cash flow, paying off debt can give you greater financial flexibility and peace of mind, allowing you to make more strategic decisions about your money.

Paying off debt reduces stress and anxiety

Debt can be incredibly common, and it can have a profound effect on your well-being. Research has found that having unmet loan payments was associated with significantly higher rates of depression and suicidal ideation compared to having no debt or being able to pay off debts on schedule. Debt can also affect your physical health, with financial anxiety releasing stress hormones like cortisol and adrenaline, which can cause problems with immune system functions.

Paying off debt can reduce stress and anxiety by:

• Removing the burden of debt, which can feel like a failure or a source of shame.
• Helping you regain a sense of control over your financial situation.
• Reducing loneliness, which can make things worse and cause increased anxiety or mood changes.
• Improving your cognitive function, financial decision-making, and ability to plan ahead.
• Lowering stress hormones, which can lead to improved physical health.

Additionally, paying off debt can improve your credit score, making it easier to borrow money in the future, rent an apartment, or open utility accounts. It can also lower your interest rates and free up cash to add to your emergency fund or kickstart your investing plan.

Frequently asked questions