Tuesday, August 24, 2010

Pay Off Debt or Invest?

This is a simple question which can lead to complex answers. The short answer would be to pay off all your bad debt before attempting to invest your savings. As discussed in an earlier article there are two different kinds of debt and it is important to distinguish between the two: http://reynold-savemoney.blogspot.com/2010/08/know-your-debt.html . But in most cases it's best just to pay off any money that you owe, because it would be terrible to waste your hard earned cash on interest.

So before we delve into the world of investing, it is best to first talk about debt. Now that you know the difference between good debt and bad debt it would be wise to tackle all of your bad debt. This would be your credit cards, vehicle payments, and the mortgage on your own home. Also included in this category should be any student loans. While you were going to school there probably wasn't any interest accruing, however a month or two after you finish school the interest clock starts. So it's best to get that debt off your back as soon as the interest starts accruing or better yet before the interest clock starts.

There's an excellent book by David Bach entitled the Automatic Millionaire. He explains a very simple method of paying off consumer debt (which is the worst bad debt) known as the DOLP system, which stands for Dead On Last Payment. Basically the best way to pay off consumer debt is to pay off your credit card with the lowest balance first, not the card with the highest interest rate. There is an interesting formula to rank which debt to pay off first. I've included a link that allows you to calculate and rank the credit cards you should pay off first http://finishrich.com/dolp/ .

It's important to note that it can be very difficult to invest your money for growth when you still have outstanding debt. An investment can be measured by what is called a return on investment (ROI). This is an annual rate of return that you get on your investment which is measured as a percentage. For instance, if you invested $100 in Company A and at the end of the year you receive $110 on your investment you have just received an ROI of 10%. You just made an excellent investment! However, if your credit card debt of a $100 is charging your 19% interest you're really losing 9% to the credit card companies, not to mention penalty fees for not making payments. So it's important to understand the debt that you're in and seriously consider paying it off before investigating your investment options.

I've included a video by David Bach about his DOLP system. The first minute is him trying to sell his book so I would skip to the 1 minute mark and listen to it to about the 2:20 mark. Let's get that debt off our backs and move on with our lives to a better financial future!


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