Pay Off Debt or Invest? Think About Your Rate of Return
Andrew writes in:
My girlfriend and I bought a home last year and qualify for the First Time Homebuyer Credit. When you include my share of this, I will be getting back around $4500 in my tax refund. This is a lot of money to me and I’m trying to decide what to do with it. About half will go toward an engagement ring, but I’m torn between investing the other half or paying off my $2,000 in credit card debt. I currently have a very low APR on the credit card and can pay more than the minimum each month. As a licensed broker, I am very involved with the markets and believe I can make 10-15% a year. If I can get a higher percentage return on the investments than the APR I pay on the card, doesn’t it make more sense to invest?
In essence, Andrew is comparing two rates of return here.
First, there’s his credit card. An investment in paying off a credit card has a guaranteed rate of return – the interest rate on the card.
On the other hand, there’s the stock market. An investment in the stock market might have a higher hypothetical payoff, but it’s not guaranteed at all.
Regardless of whether the year was 2008 or 2010, paying off a 9.9% credit card will net you a 9.9% annual return on your money. Alternately, if you were able to get a 10% return on your stock investments in 2008, you were an absolute magician.
The reason that the standard advice is to pay off your high interest debts before you invest is because paying off high-interest debts is a far better investment than the stock market. Why? That rate of return is guaranteed ...
