How to balance paying debt vs. investing

[Music] let's say you're at a place financially where you're able to start saving rather than living paycheck to paycheck a situation that describes more than one in three American workers across many different income levels after covering your monthly expenses like groceries Health Care your rent or house payment you've got $200 left over what should you do with this money there's two places people usually look paying off their debt or investing in the stock market to watch the money grow and save for retirement so which one sets up for a better Financial outcome in the long

run there's no simple answer but there is a rule of thumb that can help you start thinking about [Music] this the number that experts say tips this scale in either direction be it pay your debts or invest is seven that's a 7% interest rate the amount by which a debt or investment grows over time you'll sometimes see this Tipping Point number as 6% or 5% after factoring in considerations like how close a person is to retiring but since 7% is the low end of the growth you can expect from investing over time that's where the

scale will balance out for the purposes of this video if your debt has a lower interest rate below 7% it's considered mathematically more beneficial to put that $200 toward investing in an index fund an investment fund that tracks the performance of a market index like the S&P 500 for example these are a hands-off way to invest your money that generally carry a lower risk than investing in individual stocks the S&P 5 500 going back decades grows at an average rate of about 7% when adjusted for inflation some years are much higher than that and some

years are much lower but generally if your debt interest rate is below 7% you stand to earn more over time by investing rather than tackling the debt right away past 7% though the interest adding to what you owe outpaces any growth you could reasonably rely on through investing the way to think of it is just which one enhances your net worth from year to year because it is sort of a balance sheet issue what you own minus what you owe and I think 7% is a good guideline looking at the math really shows how this

7% rule of thumb Works let's say you have $10,000 in debt at a 5% interest rate that's about the average rate of federal student loans for undergraduates over the past 10 years and let's say this debt has a monthly minimum payment of $150 that you have to pay every month along with all your other necessary expenses there's a bunch of calculators online that can show you how long it will take to pay down this debt based on your monthly payments and how much total interest it will cost you in the end in our hypothetical scenario

if you pay just the minimum payment without contributing anything extra it will take you about 6 and 1 12 years to pay off this debt and you will have acred around $1,700 in interest on top of the original $1,000 but if you put that extra $200 per month as an additional payment toward this debt it's gone in 2 and 1/2 years and your total interest is under $700 paying it off faster means you have $1,000 more in your pocket but let's go back to scenario one you pay your debts minimum payments and rack up $1,700

in interest over 6 and 1/2 years and during that time period you invest your $200 per month into the S&P 500 instead of paying down the debt sooner even at the more conservative 7% expected rate of return you end up earning around $4,000 in total interest so sure you've added $1,700 of interest to your debt but you earned $44,000 by investing that's $2,400 extra in your pocket instead of 1,000 from paying off your debt faster but now let's crank this debt interest rate up to 13% a typical interest rate to take out a subprime loan

one given to someone with a below average credit score to buy a new car paying just the minimum payment it would take you almost 10 years to pay this off and you'd have racked up $7,800 in interest on top of the original debt but if you put in your extra $2 $ per month here this debt is gone in just under 3 years and you'll pay around $2,000 in interest so you come out ahead by $5,800 in interest saved by using your money to get this debt paid sooner so let's do the invest scenario for

this one if you pay just the minimum payment on your debt and invest your $200 per month over those 10 years you can conservatively expect to earn around $10,000 in compound interest which sounds nice but when you subtract the $7,800 the debt grew in interest you end up with a net gain of just under $2,400 which is less than half as much as you would have ended up with if you had paid the debt down sooner so whichever side of this scale accumulates more interest has the higher rate of return that's where you generally want

to put your money of course using seven as the Tipping Point on this scale is just a rule of thumb and life is much more complicated than a single math equation plus different kinds of debt carry dramatically different costs let's unpack that after a quick word from this video sponsor thanks Coleman while investing can feel overwhelming at times with Robin Hood gold you get a full Suite of solutions to help you navigate your financial future Robin Hood gold is a subscription service that can supercharge your cash with rates and products usually reserved for the 1%

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make videos like this possible now back to the video the largest total debt in the US in dollar amounts is from mortgages these are long-term loans that generally have lower fixed interest rates usually below 7% % then there's student loans the next highest debt amount in dollars but also often with low interest rates especially at the undergraduate level one of the harder to manage sources of debt is credit card debt credit card interest rates have been turning above 20% for the last few years and can go even higher especially for people with lower credit scores

the likelihood that even the most Savvy investor could consistently reach that level of return from the stock market is very very low when you have debt that is growing at over 20 % there's almost no reason not to eliminate that as soon as possible a federal law pass in 2009 actually required credit card companies to display on each statement how long it will take to pay off the debt and the additional interest incurred by going with the minimum payment and show you what you need to pay each month to eliminate the debt in 3 years

plus what you'd save an interest by doing it there's one other important step a financial planner will tell you to take care of before deciding what to do with extra cash and that is to have an emergency fund set aside just in case the guidance you'll often get is for this fund to be at a minimum $1,000 to cover an unexpected expense ideally though this security blanket is bigger the classic advice is 3 to 6 months of must pay expenses that's the mortgage or the rent that's the groceries that's Health Care things like that the

experts I talked to for this story emphasized that any investment in the stock market always comes with some risk and that could be a big factor for someone choosing between these two paths 7% rule or not I will just double down on there are no guarantees in the stock market you have so many more options and so much more flexibility if you're debt-free there's just a a benefit to being debt free that you really can't quantify so if you're someone who would rather avoid the risk of investing no matter how high or low your debts

interest rate is well then you have your answer [Music]