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Is Bad Debt Management Hurting Your Investment Returns in the Stock Market?

By Ryan Downie – Jun 21, 2021 at 8:26AM

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Your debt might be influencing your stock market returns in ways you don't even realize.

We aren't taught that debt management is a part of stock investing, but it actually is -- all of the different decisions in your financial life are interconnected. Obviously, your loans can't impact how much a stock's price rises or falls. However, mismanaged debt can drastically reduce the amount you have in your stock portfolio down the road. And the best possible debt management strategy isn't as simple as avoiding it altogether.

How debt interacts with investments

Capital allocation decisions carry opportunity cost. You have to decide what you do with every single dollar you save. If you pay down debt, you miss out on the returns you could have been earned by investing that money. If you purchase stocks while carrying debt, you incur interest on the balance that you could have avoided. These factors need to be considered if you want the best possible financial plan.

The decisions you make around loans have ramifications for the amount of cash available for investment. When all aspects of your financial plan are acting harmoniously, it helps you avoid emotional decision making, such as taking on too much risk to chase returns.

Happy person managing credit card debt on a computer.

Image source: Getty Images.

Good debt vs. bad debt

There's something to be said about living debt-free and the associated stress relief. However, you can use loans responsibly without inhibiting yourself or hurting your financial plan. It's important to know the difference between destructive debt and loans that can be healthy when utilized properly.

"Good" debt carries low interest rates, and it's backed up by assets that have relatively stable value. The more liquid and less volatile those assets are, the better. Mortgages and HELOCs are generally considered a healthy form of debt, because they tend to have low interest rates and are backed up by real estate. Loans that are secured against bonds and low-volatility stocks are even better. It's easier to convert stocks and bonds into cash, which is a great safety valve if you carry debt.

Think of it this way: Healthy loans could potentially be eliminated whenever you please by selling the assets that back them up. You can choose to keep those lines of credit open in order to use that capital more effectively somewhere else in your financial plan.

"Bad" debt includes unsecured loans with high interest rates. Credit card balances fall under this category. They are unsecured loans that can have interest rates well above 20%. It's unlikely that you'd achieve long-term returns from any investment that's higher than that interest expense, so it's a good idea to focus on eliminating credit card balances before you invest too heavily in the stock market. Unfortunately, many households carry a credit card balance, though the total amount outstanding has dropped drastically over the past year.

Student loans fall somewhere in the middle. They have moderate interest rates, and they aren't backed up by other assets. They can be a necessary financial tool to achieve an education and improve earning power. However, your ability to repay is entirely based on future income, which isn't guaranteed.

The real-life decisions you'll make

Focusing on bad debt before investing in the stock market can actually unlock better long-term returns. Some credit cards can have serious consequences if you carry a balance. People commonly make unmatched contributions to their 401(k) while paying more than 20% interest on a credit card. These two decisions don't make sense together.

You're unlikely to average over 20% returns each year in your investment account. Every dollar that you're investing rather than using to eliminate debt is actually reducing the amount you'll have available to invest in the future. That's why it's important to focus on this bad debt before investing. Over time, you can purchase stocks with the cash you save on interest. In the long term, your stock portfolio will be higher if you follow this order of operations and invest all your savings from credit card interest payments.

On the other hand, paying down healthy debt too quickly keeps you from maximizing investment gains. Your mortgage likely bears a low interest rate that's not destroying your financial opportunities while you build equity in a home. Thirty-year fixed mortgage rates are around 3% right now. Any payment you make above the minimum generates minimal savings. Assuming long-term S&P 500 index returns of 8%, you're losing 5% on any amount you pre-pay in the long term versus a simple index fund.

If you invest rather than paying down healthy debt, you're creating a liquid asset pool that can be used however you like. In the future, you can pay down your loan balance in a lump sum. You'd probably have more money left over than you would have if you just paid down a mortgage each month. Obviously, there's risk entailed by accepting interest expense in favor of growth potential. That's why you need to have a long-term and relatively low-risk investment strategy to make it work. Diversified index funds are probably the best route for most investors for this purpose.

When you recognize that your financial decisions are intertwined, you open the door to improved outcomes in your investment portfolio. You'll gain flexibility and control along the way too. You might want to have some extra cash to throw around the next time the stock market crashes.

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