Although it may seem confusing at first glance, it should come as no surprise why financial advisors encourage you to start savings when you have a pile of debt. Why do they advise this way? Because financial advisors are commissioned salespeople. If they do not sell you their product (investments) they do not get paid.
Okay, the power of compounding is certainly a valid argument that advisors will make. However, this argument is invalidated if you carry $22,100 in debt like the average American and your income hovers around the median. In other words, a few bucks in credit payments is different than struggling with payments and investing at the same time.
We can see whether the argument is valid once we know our Cash Dilution Rate. This rate essentially tells us how much of our after-tax dollars we lose to the credit debt we have. So, the higher the rate, the more we pay to creditors; the lower the rate, the more of our after-tax dollars we enjoy and, therefore, can afford to invest without sacrificing our lifestyle.
Taking a closer look, we can consider someone who earns $2,000 in after-tax income. Match this to the average American debt of $22,100 that carries an average rate of 13.35%, and this individuals sees only $1,732.86 of her $2,000.
For a better appreciation of this situation and how severe it can be, let’s pretend her advisor encourages her to invest a “modest” $250 per month. Combined with the $267.14 she pays in credit debt, she is left with less than $1,500 to enjoy the rest of her life. Even though she started with $2,000 she loses an additional 25% and has much less to pay for other expenses like rent, mortgage, entertainment, etc.
Now, if this individual had no debt at all, the $250 might make perfect sense as she is already spending more than that on her debt payments. So, what impact does paying debt and investing have on her long-term savings? Of course, there is no easy answer because there are two things we need to consider.
Our first consideration will be whether this individual can afford the $250 that the advisor recommends. In the event that she can, she should actually take the $250 and bulk up her credit repayment plan (assuming there is absolutely no guaranteed financial incentive to invest such as an employer-matching program). Doing so will reduce her repayment schedule from 57 months to less than 35 months. In other words, she will be debt free in less than 3 years, at which time she can realistically invest both the “affordable” $250 that the advisor suggested and the $267.14 that she will no longer have to repay toward her debt, for a total monthly investment of $517.14
Another factor weigh is timing. If our investor has only 15 years left, as of today, that means she loses 3 years of potential compounding. The impact will this have on her savings is minimal. By deferring her $250/month savings and repaying debt instead and then, in three years investing $517.14 per month instead, this individual will have saved $38,283 more over 12 years (remember, she lost 3 years by repaying that debt first) assuming the rate of return is constant and she can still invest $250 plus the $267.14 she saves in credit repayments. More importantly, after 3 years, she will be debt-free, which automatically puts her in a better position to tackle unplanned financial hardships.
Another way to look at this is to assume that after nearly three years of paying $517.14, she wants to start enjoying more of her life and decides that instead of investing $267.14 (what she saves in credit payments) plus the full $250, she invests only one half of the $250 and spends the other $125 on something frivolous (like shoes). Spending $125 on shoes allows just $392.14 to be invested. Taking into account that she starts investing three years later, she would still come out farther ahead than if she invested $250 per month today (she would be ahead to the tune of $7,167, it turns out).
Either way, repaying debt should take priority in nearly every sound financial plan, even though repaying debt is much less glamorous and nowhere near as exciting. Of course, there are some instances and arguments where debt repayment might not always be the wisest decision, but those situations are quite rate.
