Why should people pay off high-interest loans and credit before starting long-term investments?

Also, What happens if you pay higher interest on loans than you earn on investments?

I know these questions are somewhat "duh" but I need clarification!

easy. so that the interest paid doesnt surpass the interest gained. think about it this way... you are paying 18.99% on your credit card. you are earning 8% on an investment. what is going on? you are losing money to the credit card. if you have extra money, the first thing is to eliminate the debt so you arent throwing away investment earnings. once the debt is gone, then your extra money can go to investments... the more money you can put in, the more your wealth will grow exponentially.

because you will pay more in interest than you will the actual loan

Investing money in low return investments when you are paying high interest on loans is counterproductive. You are going to make less money from the investment than you are paying out in interest on the loans, so your best investment would be to pay off the loans first.

because you pay out more money in interest than you can earn in investments in the same anmount of time

One-questioner,
I am NOT a financial advisor but I do know that by paying off the high interest debt you will get ahead quicker. The high interest debt will eat away at you quicker than the interest rate that you are likely to get on any investments. You will also be able to invest a larger amount regularly which allows the compounding to be greater. Have a wonderful day and a glorious LORD's DAY!
Thank you,
Eds


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Fatty & Marti,
You have done an excellent job of explaining this!
Thanks...

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Because the interest rate on the credit cards and loans exceeds the return you can get on the long term investments. So let's say you are trying to start a long term investment and you will probably get a 10% return on that, whereas you still owe on your credit cards where the interest you pay might be around 20%.

If your long-term investment is paying less than your short-term debt or high-interest loan of the same amount is costing you, then you are losing money overall. So rather than invest the money, it would make more sense to take the money and pay off the high interest loan

Because the average 5 year rate of return on long term investments like a stock portfolio is about 10% per year. If you have credit card debt at say 19% interest, you are paying out far more interest than you are earning. If you are paying 29% interest on credit card debt, your debt load will be growing 3X faster than your investment income.

Pay off the high interest debt as quickly as you can, and then invest.

Two main reasons:

1) Because the stock and bond markets are predicted to provide long-term average returns in the single digit percentages (like 7 - 8% for stocks) over the next 30 years, whereas credit card companies charge you interest in the double digits (like 12 - 18%). You literally cannot "outinvest" the credit card companies. If you do not first pay off high-interest debt you will be forever in a negative-sum game, because the credit card companies are compoudning the interest against you.

2) Because when you pay off credit card debt, your money receives a known return of the same amount as your interest. Paying off debt means you make money ... well, you actually save money by not paying the interest, which is "making money." You get a gauaranteed return on your money when you pay off debt. With stocks and bonds, your return cannot be known in advance. In fact, you may temporarily lose money from stocks. In contrast, you never "lose money" by paying down debt.

There is only a limited amount of lifetime income a person will generate. In essence, the first 20 years of your life are free, thanks to parents. After that, people must then take 40 years of working income and spread it over 65 years of living. So, unless you plan to work up till the day you die, or plan to committ suicide on your 65th birthday, you must - out of necessity - spend less than you earn. Getting into debt is actually going in the opposite direction. Debt means you are actually spendine MORE money than you earn.

The biggest killer of financial freedom is consumer debt. The first step in building wealth is to rid yourself of this. It is not intelligence or skill that builds wealth. It is discipline that builds wealth.

Read my free book on retirement investing. Click on my profile and read my info to get the website. The book is in PDf format.

Think about it, would you take a loan that charged you 10% interest to invest in a fund that paid you 8% interest? I hope not!

But in effect, that's what you are doing if you have a credit card balance that's costing 10% APR, and you invest $1000 in a mutual fund paying 8% instead of sending that $1000 to the credit card!

Just do the math for your particular situation....more likely than not, you'll win more by paying down debt than by building up investments. And you'll get rid of the debt faster, too!

Best wishes!

Its like a lot of posters are saying. The interest and finance charges swallow up any gains from investing and defeat the purpose of investing. You're better off using the money to pay off the debt first.

Well, ideally you would do both at the same time...perhaps, but interest is THE KILLER in handling financial debt issues. The debt never goes away if you just make minimum payments. It depends on your age too. If you are young, you SHOULD be saving so you can have as much as possible by the time you retire, but at the same time if you have high debt with high interest you need to get rid of that before you can really move forward effectively. At least you have many years to get it together if you are young. Get rid of that debt, and start saving as soon as you can.

Suppose you had $10k in high interest debt, say the "common credit card" charging, say 20 percent (most of the offers I get are under 10 percent, but most of the offers my son gets are over 20 percent). What that means is that interest on this card will cost you at least $2,000 over the year. Now if you had $10k in a common savings account and happened to catch a good buy, you might get something like 5 percent APR (or some fractional amount over it in final yield), like I saw at the bank branch at my grocery store today. This means that the $10k in savings will pay you $500 in the same year that you pay your credit card company $2,000 for a similar amount of debt. Of course, if you borrowed 10k from your card to put in savings, then you are paying 2k to get 0.5k, a net loss of $1,500.

It isn't just in stocks that we follow the old adage of "cut your losses, but let your winnings run"--so before you can properly realize winnings, you've got to cut your losses, right?

Next question, to finish the example, is are you really, really, really sure that your stock strategy definitely, for sure, will do you not only better than money in the bank, but better than your debt on the credit card? Hmm, a lot of folks don't get that kind of result on a steady and regular basis.

Added note: How does this happen? There was no answer on this question when I started a five minute answer writing, but now there are a pile of them and the newest is 3 hours old! Sheesh, somebody wake Yahoo up.