Pay Off Debt or Invest for the Future?

Many people experience a great deal of angst when it comes to the question of whether you should pay off consumer debt or invest for your future needs with any extra cash on hand.

Conventional wisdom states that your money is best used by seeking out the best rate of return available. To that end, traditionally, no investment could even touch the returns most people can get from paying off their credit cards. With interest rates solidly in the double digits, paying off credit cards and other high interest debt is a no brainer. 

But what about lower interest debt? Student loans, a car payment, or even a mortgage? 

Should you keep making your regularly scheduled payments while squirreling away cash for the future, or attack your debt and eliminate all the payments you can before investing?

How to Best Use Your Capital (Traditional Wisdom):

Over the last 200 years, the stock market has returned around 10% per year including reinvested dividends. 

Using this 10% average as a benchmark, many people choose to pay off any debt with an interest rate in excess of 10% while making the regular monthly payments on any accounts with an interest rate in the single digits, believing that their capital will be better used by investing for the future rather than paying down debt.

There is one major flaw in this logic.

The Problem with the Traditional Wisdom: 

In a predictable and orderly existence, this would be an excellent plan. But our society is neither predictable nor orderly, and the only certainty in life is change.

For example: If you lost your job today, how long could you survive with the same lifestyle? If you subscribe to the conventional wisdom, continuing to make payments on your debt while investing in the markets with your extra cash flow, the answer is likely to be "not long", even if you have an adequate emergency fund.

Now, if you lost your job and were free of all debt payments, how long could you survive on the same emergency fund? The answer is likely very different, because your expenses would be much lower. Free of debt repayment, most people could not only cut down on their financial stress, but also experience a huge increase in their lifestyle and savings rate.

Seeking Financial Freedom:

First on the list of anyone's financial priorities should be what we at compounding returns call financial freedom. 

Financial freedom does not mean that you'll never have to pay another bill, or work another day in your life.

Financial freedom begins when you have stopped working for others, and begun to work for yourself in order to secure your own financial future.  

When you are a debtor, you make others rich by offering them returns on their invested capital. When you are debt free, however, you can begin to make yourself rich. Put succinctly, if you owe money to anyone, you are helping them to grow their investments over time, while robbing yourself of the extra cash flow that you could be saving and investing to seek your own wealth over time. 

Seek Financial Freedom by Eliminating Debt:

So, should you pay off debt or invest? At compounding returns, we believe that for most people, the answer is to pay off all consumer debt as soon as possible. This will not only free up cash flow and ensure returns, but will help most people sleep at night, knowing that you will be free to build your own wealth instead of that of the banks or financial institutions' shareholders.

Photo By: Robert Scoble