According to our household's financial records, we currently owe a total of $112,165.20 in debt. That is a combination of our mortgage and the current balances on our credit cards. Yet despite that whopping six-figure debt load, we are actively investing and have been doing so for years. The reason is simple: Not all debt is automatically bad, and if you can beat the cost of your debt from your investments, you can wind up ahead.
If you can structure your finances so that your debt load consists of reasonable obligations, you too can consider investing while still carrying debt. The key is to make sure your debts have three distinguishing characteristics. First, they must be at a low interest rate. Second, the mandatory payments must be manageable with your current income. Third, the debt must serve a useful purpose for your future.
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Why interest rates matter
Ultimately, investing is something of a numbers game. You're looking to earn a decent return on the money you've invested. If it costs you more to borrow money than you can reasonably hope to earn in return on that money, then it makes no financial sense at all to invest while you owe that debt. Use any extra cash you can free up to pay off that debt with a high interest rate, and you will be better off than if you invest it.
Even if it's close, it generally makes more sense to pay off your debts than to invest, because paying off debt provides a guaranteed rate of return while investing does not. Plus, once you pay off a debt, you no longer have to make the payment. That payoff frees up cash flow that you can put toward any legal purpose you'd like, instead of your cash having to go to that debt.
In our case, our mortgage is at a fixed interest rate below 4%. As for the credit cards, we pay those off in full every month, so we don't pay interest on them. On top of that, the two credit cards we use the most offer cash-back programs, so in effect, we pay a slightly negative interest rate on those cards.
Over the long run, the stock market has delivered compound annual returns near 10%. With our most expensive debt charging a rate below 4%, we can likely outperform that debt over time by investing, even if the market somewhat underperforms its long-term historic return rate.
Why mandatory payment levels matter
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Debt payments are mandatory. Start missing payments, and at a minimum, you face a ding to your credit rating. In addition, there's a good chance you won't be able to borrow in the future or your rates will begin to skyrocket. With secured loans like your house or car, if you miss payments, you can see the underlying asset repossessed. And if you miss payments on your student loans, you can even see your Social Security payments garnished to make up for the missing money.
Because not paying your debts can have serious consequences, and because money spent on debt payment can't be used anywhere else, it's important to keep your mandatory debt payments low. That way, you have a better shot of having the money to cover both them and the rest of your core lifestyle costs. In addition, the lower your debt-service costs, the better the chances you'll be able to still make the payments if you find yourself forced into a lower-paying job.
In our case, our mortgage consumes about 20% of our pre-tax household income. That's within the standard guidelines that people typically use when talking about home affordability. As a result, most of the time, we can cover that payment without issue. Still, when my income dropped for a few months due to an injury, we quickly recognized the value of keeping that cost in check.
As for the credit cards, we use them because they're safer and more convenient than cash or checks. In addition, unlike a debit card, if our credit card information is stolen, the thief won't have access to our bank account. The cash-back rewards are the icing on the cake.
Why having your debt serve a useful future purpose matters
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If you're like most of us mere mortals, you only have a certain amount of money that comes in every month. You need to stretch that money across all of your needs and enough of your wants so that you're enjoying life along the way while still socking away something for your future. That's a tall order, and it's easy to get frustrated and want to give up even trying to save and invest for a better tomorrow.
A house gives you a place to live. A car can get you to work to earn a living. An education may make you more employable and offer you the opportunity for a better salary. Medical care can keep you alive. While your monthly costs will certainly be lower if you aren't carrying those types of debts, sometimes it may not be feasible to avoid them. As long as your debts for those types of things also meet the other characteristics, it can be OK to make the choice to invest while carrying the debt.
In our case, we still owe on our mortgage and are paying it off. From a car perspective, once we paid off our last car loan, we kept "making the payments," but to a savings account instead of to the financing company. Since then, we've used the money we've saved to buy our cars for cash. We value the flexibility that gives us, especially since we have a teenager about ready to start driving, and we expect our insurance costs to skyrocket shortly.
Get yourself into a position where you can invest soon
The sooner you can start investing, the longer you can get the market's long-term compounding working on your behalf. That can help you more than almost anything else when it comes to building long-term wealth.
If you've been hesitating on investing because you've worried about your debts, prioritize paying off the ones that don't meet the criteria I listed above. Then, you can make an educated choice as to whether you want to invest while carrying reasonable debts. When your debts are at a low interest rate, carry a low payment, and meet a clear need for your future, you are in a much better spot to make a good choice for yourself.
