In another approach to Phase I: The Foundation Phase, Step 4, Pay Off All Consumer Debt, we’re going to emphasize the need to pay off debt before investing in stocks. While that may seem like something of a repetition of our general advice to get out of debt, it actually rates a special discussion when it comes to investing in stocks.
There’s a myth – or perhaps an excellent example of wishful thinking – that it’s possible to invest your way out of debt. That’s a process of investing and growing your money until it reaches the point where it’s greater than your debt obligations. If only that were possible. More often than not, human emotion gets in the way, and the strategy turns into a recipe for failure.
Investing – especially in volatile securities like stocks – requires a long-term perspective. That’s best developed from a good running start, like paying off your debts before investing. We’re not talking about paying off your mortgage, or even a car loan, but you should certainly plan to pay off credit cards and any other types of consumer debt you have.
Here are some reasons why you should pay off debt before investing in stocks.
1. “The debtor is slave to the lender.” (Proverbs 22:7)
As Christians, we should read that verse and have as much information as we need. God is warning us that debt arrangements put us in a position to lose our independence. No good ever comes out of that situation.
Of course, God has given us that warning because one of the complications that debt creates is interfering in our walk with Him. That’s not a stretch either – when we take on debt, the creditor can begin to take on God-like status in our lives. You may want to please God, but it will be difficult to do if you have debt, and especially too much of it.
The same will be true with investing; if you have debt it will interfere with your investing efforts.
2. Paying off debt will provide the discipline needed to save for investing.
One of the fundamental components of successful long-term investing is developing the discipline to fund your investment portfolio on a consistent basis. It will not be possible for the average investor to simply take a small nest egg and grow it into a huge portfolio by smart investing alone. You’ll need a combination of solid investment returns, supplemented by ongoing contributions.
One of the reasons why people get into debt in the first place is because they lack the discipline save money. The silver lining on paying off debt is that it’s the very process that could help you to develop that discipline. You’ll need to make regular monthly payments – in excess of the monthly minimums – in order to pay off your debts. Once you’ve been doing that for a few months or years, you simply need to carry the practice over to funding your investment portfolio in Phase II: The Accumulating Wealth Phase. That will be a seamless transition.
3. There’s a difference between speculative gains vs. guaranteed expenses.
It’s important to understand from an investment standpoint that debt and investments are not created equally. All debt carries legally enforceable repayment obligations on your part, which includes the payment of interest. Investing – and investing in stocks in particular – carry no such guarantees.
If you invest in stocks before paying off debt, you’ll be attempting to match an uncertain investment return against a guaranteed debt service. Though your credit card debt may require you to pay 10% interest annually, your stock portfolio most likely rely primarily on capital appreciation – and that’s never guaranteed.
You could lose 20% on your stock holdings, but still have to pay 10% interest on your credit card debts. That’s an unequal arrangement, and that’s why you need to pay off your debt before investing in stocks.
4. If the stock market crashes you’ll be REALLY sorry!
There is a potential “nuclear nightmare” situation that stock investors who also carry debt don’t want to think about, and it’s best illustrated by example.
Let’s say that you have a $20,000 stock portfolio, and $20,000 in credit cards and other consumer debt. You feel comfortable with the arrangement because you have sufficient assets to pay off your debts at any time. You may even view the arrangement as more of a convenience than anything else.
Suddenly, the stock market goes into crash mode. In a matter of months, your stock portfolio falls by 60%, and you now have just $8,000.
But your credit card debt? It doesn’t fall at all during the crash! It’s still at $20,000, only now you no longer have the assets to pay it off should you choose to do so.
At one time you did have the money to pay off your debt – but that money is now magically gone, and your credit card debt is still there.
There is probably no real life situation that can make the case for paying off debt before investing in stocks better than this one. Reality has a way of demolishing the most optimistic assumptions!
5. You don’t want to play with money you can’t afford to lose.
If you have unsecured debt when you’re investing in stocks, the debt functions as something like an unofficial margin loan against your portfolio. No, they’re not directly tied together, but unsecured debt represents a reduction in your liquid assets.
Considering once again the crash scenario outlined above, if your stock portfolio were to plummet, you would quickly realize that you’re playing with money that you can’t afford to lose. Making matters worse, job losses often accompany steep declines in the stock market. Should you lose your job in addition to taking a big hit on your portfolio – well, you get the picture . . . .
6. You can free up your cash flow to build your investments.
Earlier we talked about the need to use a combination of investment returns and contributions to build your investment portfolio over the long-term. This will be significantly more difficult to do if you are servicing a substantial amount of debt.
Debt represents a reduction in cash flow, that means that there’ll be less cash flow available to fund your investment portfolio. During years with negative returns in the stock market, this reduction in contributions could make investment progress difficult to come by.
Paying off debt cleans up your budget, and frees you to concentrate on the task at hand, which is growing your investment portfolio.
7. It can keep your mind clear.
Life is complicated in the 21st century – there’s no doubt about it. We’re all trying desperately to multitask – but multitasking is one of those kind-sounding activities that’s heavily overrated. The reality is that you can handle only so much before all the activity begins to interfere with your ability to think clearly.
By paying off debt, you remove one major item from your to-do list, and that frees up your time for more productive activities. In addition, since debt is a source of worry, it has a way of interfering with free thought. The sooner you pay it off, the easier it will be to concentrate on everything else you’re doing in life, including building your investment portfolio.
Though it may seem like an annoying extra step, paying off debt before investing in stocks is one of the best preliminary steps you can take to becoming a successful long-term investor. Bite the bullet now, clean up your finances, and free yourself to concentrate on building up your net worth. You’ll never regret it.
Are you avoiding paying off debt and investing instead? Why? Leave a comment!