Paying Off Debt vs. Investing in this Economic Environment

by Kevin on October 8, 2008

I’ve been pondering this debate for a few weeks. If you have debt, should you be paying it off or investing for the future? The markets have tanked roughly 37% since October of last year. Is there a buying opportunity there or do the markets have room to fall more?

This is a blog about living a debt free life.

Naturally, you should expect my answer to be pay off debt. My No Debt Plan is designed to get you out of debt before you start investing heavily. Step 4 is Pay Off All Consumer Debt. I haven’t even gotten to the investing step of the No Debt Plan. I am very anti-debt!

“But the markets are so far down, shouldn’t I be putting money in now?”

I will grant that point. The markets are down. Way down. Waaaay down.

But putting money in only when the market looks down, or looks up, or looks flat, or whatever “trigger” you want to use is called timing the market. It has been proven that if over the last 70 years or so, if you missed the 25 best days in the market, your returns were severely hampered.

Ramit Sethi of iwillteachyoutoberich.comhas a book coming out and mentioned this on his blog today:

Recently, a group called Dimensional Funds studied the performance of the S&P 500 from January 1970 to December 2006, during which time the annualized return of the market was 11.1%. They also noted something amazing: Of those 36 years from 1970 to 1986, if you missed the 25 days when the stock market performed the best, your return would have dropped from 11.1% to 7.6%, a crippling difference.

That’s a 3.5% annualized return difference against timing the market. Over 36 years that is bound to be a ton of money you’ve missed out on. Timing the market is impossible. On a daily basis it is a coin toss on whether or not the market will go up or down that day. So what should you do?

Have a financial plan

Planning, planning, planning. I’m all for planning. A well thought out plan pretty much answers all of your financial questions for you — and it answers this question, too.

I’m not saying you have to follow my No Debt Plan down to the very specifics. If you think you should continue to invest regardless of the market while paying down debt at a slower pace, then stick with your plan.

If I were in debt right now, it would depend on the level of debt for me to make a decision. If I were thousands of dollars in debt, I would probably limit my investing to small amounts — but I would keep investing. If I could knock out my debt in a few months, I would knock it all out as soon as possible.

Debt repayments are good returns

While the market has fallen 37% over a year, if you made debt repayments you are earning a positive return. Let’s say you have a credit card with a 15% interest rate holding a large balance. For every dollar you pay off, you are earning a significant return because you are eliminating interest. You can’t retire off of eliminated interest payments, but it helps you get out of debt faster (and thus move on to investing faster).

My general advice: pay off your debt as quickly as possible, then develop an investment plan.

What do you readers think? Are you in debt and continuing to invest heavily? Have you changed strategies recently from debt to investment or vise versa? Leave a comment and join the discussion.

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