Investing before paying off debt – does it make sense?

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Being in debt is sometimes confusing. You may fail to take advantage of great investment opportunities because you feel trapped in debt. So does investing before paying off debt makes sense?

Every month you watch debit orders being deducted from your bank account and you wonder how long this will continue to terrorize you. Debt is not good especially if it is being used to sponsor a lavish lifestyle. Even though the source of your debt might be student loans, having to pay for that from your small graduate salary is very stressing. Therefore, there is a need to get rid of debt fast. Should you start investing before paying off debt?

Many financial advisors encourage people to focus on paying off their debt first. That makes sense but not always. Let us take this down to a more personal level. People are different and one solution is not always the master key to everyone’s problems.

Investing before paying off debt depends on:

1) The interest rate you are paying on the debt

Suppose that you are paying 15% interest per annum compounded monthly on a R 20 000 credit card debt, and by saving your extra cash (say its R 2 000) in the bank you get 5% interest compounded monthly. Since the interest you are paying is more than the interest you are gaining, it makes sense to pay off the loan faster because you are reducing the loan amount fast and the overall interest amount is reduced.

We will illustrate this by using a simple example with a repayment duration of 6 months. Additional fees associated with the loan are ignored. Note also that repayments are made in arrears.

Before increasing a repayment amount

The following is the payment structure using an amortization table:

Month	Repayment	Interest	Loan repayment	Balance
1	3 480.68	250	3 230.68	16 769.32
2	3 480.68	209.62	3 271.06	13 498.26
3	3 480.68	168.73	3 311.95	10 186.32
4	3 480.68	127.33	3 353.35	6 832.97
5	3 480.68	85.41	3 395.26	3 437.70
6	3 480.68	42.97	3 437.71	0
Total	20 884.08	884.06	20 000

After increasing the repayment amount

Now suppose you decide to add an extra R 2 000 on the repayments. The above table will be revised to be:

Month	Repayment	Interest	Loan repayment	Balance
1	5 480.68	250	5 230.68	14 769.32
2	5 480.68	184.62	5 296.06	9 473.26
3	5 480.68	118.42	5 362.26	4 111.00
4	4 162.39	51.39	4 111.00	0
Total	20 604.43	604.43	20 000

Saving an extra amount

Considering that instead of increasing the repayment on debt, you decide to put the extra money in a savings account (note the first deposit is at the end of month 1, therefore you do not get any interest for that month). The following table shows your income structure:

Month	Amount deposited	Interest earned	Balance
1	2 000	0	2 000
2	2 000	8.33	4 008.33
3	2 000	16.70	6 025.03
4	2 000	25.10	8 050.14
5	2 000	33.54	10 083.68
6	2 000	42.015	12 125.70
Total	12 000	125.70

Explaining Tables A, B and C

From Table A and B, if you increase your loan repayment by R 2 000 , you will reduce your total interest payment from R 884.06 (Table A) to R 604.43 (Table B). This is a reduction of R 279.63.

However, if you decide on putting the extra money in the savings account (Table C), you earn total interest of R 125.70 in 6 months.

This shows that what you gain by putting the extra cash in the saving account is less than the interest amount you could have reduced by increasing the repayment amount of the loan. That is, you are earning only R125.75 by saving the extra cash but you could have saved R279.63 in interest payments by increasing your repayment.

Therefore, it makes sense to increase the repayment amount of the loan. As you might have seen, the total number of months to repay the credit card also reduced from 6 months (Table A) to 4 months (Table B). In this case it makes logical sense to avoid saving or investing before paying off debt.

2) Whether you are building assets or reducing liabilities

However, getting that loan paid off quickly may not be the best solution. The wealth equation is comprised of assets and liabilities. The more assets you build, the more income you receive while the more liabilities you have, the more expenses you pay. Therefore, by focusing on the asset column, you can increase your future income.

A debt is a liability because you pay interest as an expense while an investment is an asset because it has a potential to gain income.

The wealth equation is as follows:

Assets – Liabilities = Wealth

Moreover, if you invest the extra cash you have and reinvest the returns, you are growing your asset column. Please note that returns from an investment depends on how good the investment potential is. There is no limit to the returns you can get. The returns can even double your invested amount if your investment is good.

Therefore, if you focus on investing in assets like stocks, ETFs, REITs or any good investment you may think of, the income can easily exceed the interest payments. In this case, investing before paying off debt makes sense. However if you are not a risk taker, you may be better off reducing the liabilities first.

3) Whether you have an Emergency Fund

Let us consider a fresh graduate with no medical aid (medical insurance) or sufficient savings but with a student loan debt to pay. It may be a great idea to put extra cash in a secure savings account to cater for unexpected events. Life is uncertain, people can lose jobs or get sick. You also do not want to get more debt in case of an emergency.

As a result of this, it does not matter whether you are getting only 5% interest on your savings account while you pay 10% interest on your debt, you need to focus on building an emergency fund first with the extra cash. The money you are accumulating in an emergency fund is your insurance money.

Many experts recommend an emergency fund of at least 3 months worth of your monthly basic needs. Therefore, if you do not have sufficient savings, you need to focus on building your emergency fund and only switch your focus to increasing the repayment amount on the debt when your emergency fund is good enough.

4) Desire to build an investing habit

For you to build a lasting brand, it is of great value to build a great habit. Good habits may come at a cost but you should never focus on the cost.

What does this mean? Some decisions may look stupid financially today but they have a long term reward. A good investing habit is necessary if you are to achieve financial freedom. It takes a process to build this habit. Therefore even though you can be free from debt fast by increasing the repayment amount, it can reward you more in the long run if you focus on building your investment experience by investing the extra cash you have.

Additionally, you learn more by doing. Therefore you do not have to wait for many years until you finish your debt to start investing. The earlier you learn the investing skills, the faster you can achieve financial freedom.

Adding to this, the best way to stop the reliance on debt is to replace the debt habit with an investing habit. You do not want to fall into the trap of taking more debt when you pay off the debt you have now. To avoid this, you need to make sure your investing habit is good enough.

Conclusion

With all being said, it goes back to your own personal preferences. You are the one who knows where you want to be in the future. The choice of whether you should be investing before paying off debt will entirely depend on your preference. The truth is that, in the process of paying off debt, do not increase your debt. If you do, you may never be able to be debt free at all. 

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• How to build a habit of saving and investing
• First time investing – how and what to invest in