Balancing Act

Recently, I received the following question:

Dear Jason,

We are expecting to receive a lump sum payment of $65,000 in the near future. My husband and I are concerned about how to make the best use of this money.

Our question is this:

Is it better to pay off as much debt as possible, or to save the money in an interest bearing account and use the interest to pay down the debt? Our total debt is $150,000 including our car, home, credit cards, loans and medical bills. We have made financial mistakes in the past and we simply don’t want blow this money on unnecessary stuff.

Sincerely,

D.R.

Dear D.R.

This is one of those questions that we hear often. It is perhaps one of the toughest choices for people to make. Is it better to save the money or is it better to pay off my debts?

Read the full answer here:

...

First let me get the following out of the way. Savings and having an emergency fund is very critical to everyones financial well-being.

Okay, so now that we got that out of the way, I want to say that the issue here is a matter of priority and simple math (isn’t it always?).

I am going to assume that you have regular income coming in aside from the $65,000 that you are expecting. This would be the money that you are going to use to pay your ordinary living expenses like utilities, gas, groceries and the like.

Now we are going to look at typical annual interest rates and typical total return from an investment portfolio.

Let’s assume you owe $20,000 in credit card debt with an interest rate of 12%. Making the minimum payment of $300 per month it would take 9 years, 3 months to retire that debt. To add insult to injury, this would cost $33,000 over that same period. To put it simply, the credit card company is going to take the $20,000 that you owe and charge you another $13,000 in interest.

This is a long way of saying that by paying off your credit card debt it is like having an GUARANTEED effective return on investment of 12% annually.

Now we will look at your investments with a total return of 8%. The first point is that investments are never guaranteed. So the return will fluctuate over time. Some years you will have greater returns and other years will give you less. Just look at the equity market from 2000 to 2003 for proof that returns are not guaranteed. The other issue is that return is before fees and taxes so your actual average return is likely to be more like 5% annually.

So would you rather have a Guaranteed 12% effective return from paying off debt or would prefer to have a 5% return on investments that is not guaranteed?

To be clear I am not suggesting that it is bad to invest in the stock market nor am I suggesting that there are not great opportunities to realize greater returns. My point is that while you have high interest debt, I would rather lock in the effective rate of return of 12%. Once you are free of debt then it is wise to look for ways to put your money to work.

I hope this helps answer your question and I wish you good luck on your journey to financial independence.

Wishing you all the best,

Jason E. Rosen

If you have a financial question that you would like answered in Balancing Act please send your question to jrosen@rospro.com. Be sure to include your name and telephone number incase we need more information.