In a topsy-turvy world, you need to live by the new rules.
So, if you have some money saved or invested and want to see it grow, well, that’s the spirit, right? Well, for many, the biggest impediment is debt. Your investment strategy may be bogged down by education loans, car loans, house mortgage, personal loans, etc.
Does this mean you should not invest and keep postponing your investment program?
No doubt, being in debt, could make it tough for investors to make money; because if you have some high-cost debt it may not be possible to get returns higher than the rate of interest at which you have borrowed. Hence it is thought to be counter-productive to simultaneously invest as well as borrow.
Many financial planners would suggest that you pay out or cut down your debt. In other words, if you have a credit card loan at an interest rate of 42% per annum (pa), the money you are investing will have to make more than 42% pa to make it more profitable than simply paying down the debt. There may be investments that deliver such high returns, but you have to be able to find them, knowing you are under the burden of debt. I surely cannot find them.
The debt trap
You may be paying off the following:
1. THE most expensive loan
This is your credit card debt. High interest is relative, but anything above 30% pa fits in this category. Carrying any kind of balance on your credit card or similar high-interest vehicle makes paying it down a priority before you start to invest.
Personal loans at 30% pa are also included in this category. Despite a bull market (which may last another five years?), getting a 30% pa return on a sustained basis is a pipe dream. Also did you know that SIPs started as back as a year back are now in the RED? (31 Mar, 08 – today’s comment). You should also be keeping track of your net-worth and for this you could go to www.myirisplus.com which has a software that helps you track your net-worth.
2. Low-interest debt
This can be a car loan, a line of credit, or a personal loan from a bank. The interest rates are usually described as prime plus a certain percentage, so there is still some performance pressure from investing with this type of debt. It is, however, much less daunting to make a portfolio that returns 12% pa than one that has the pressure to return 25% pa.
3. Tax-deductible debt
If there is such a thing as good debt, this is it. Tax-deductible debts include mortgages, student loans, business loans, investing loans and all the other loans in which interest paid is returned to you in the form of tax deductions. Because this debt is generally low interest as well, you can build a portfolio while paying it down.
Note: The types of debt we will cover in this article are long-term low-interest and tax-deductible debt (like personal loans or mortgage payments). If you don’t have high-interest debt or, better yet, all your debts are tax deductible, then read on. If you do have high-interest debt, you’ll need to pay it off before you begin your investing adventure.
The time to invest is NOW
Debt elimination, particularly of something like a loan that will take long-term capital, robs you of time and hard-earned money. In the long term, the time (in terms of compounding time of your investment) what you lose is worth more to you than the money you actually pay (in terms of the money and interest that you are paying to your lender).
You want to give your money as much time as possible to compound. This is one of the reasons to start a portfolio in spite of debt (but not the only one). Your investments may be small, but they will pay off more than investments you would make later in life because these small investments will have more time to mature.
Instead of making a traditional portfolio with high and low-risk investments that are adjusted according to your tolerance and age, the idea is to make your loan payments in place of low-risk and/or fixed-interest instruments. This means that you will be seeing ‘returns’ by the lessening of your debt load and interest payments rather than the 4-8% return on a bond or similar investment.
The rest of your portfolio should focus on the higher-volatility, high-return investments like equity shares and equity mutual funds. If your ability (or willingness) to take risk is very low, the bulk of your investing money will still be going towards loan payments, but there will be a percentage that does make it into the market to produce returns for you.
Even if you have a high-risk tolerance, you may not be able to put as much as you’d like into your investment portfolio because, unlike bonds, loans require a certain amount in monthly payments. Your debt load may force you to create a conservative portfolio in which most of your money is being ‘invested’ in your loans with only a little going into your high-risk and return investments. As the debt gets smaller, you can readjust your distributions accordingly.
The big picture
It’s a one-point conclusion: you can invest in spite of being in debt. The important question is whether or not you should. The answer is very personal and can be determined on a case-to-case basis. There is no denying that there can be benefits from getting your money into the market as soon as possible, but there is no guarantee that your portfolio will perform like it needs to. Such things depend on how adept you become at investing.
The biggest benefit of investing while in debt is psychological. Paying down long-term debts can be tedious and disheartening if you are not the type of person who puts your shoulder into a task and keeps pushing until it is done. For many people who are servicing debt, it seems like they are struggling to get to the point where their normal financial life — that of saving, investing, etc — can resume.
Being in debt is pretty much a state of limbo state, when things seem to be happening in slow motion. By having even a modest portfolio to distract you from the tedium, you can keep up your enthusiasm with regards to finances. Knowing that the sun will come up and being able to see the dawn are very different experiences.
For some people, building a portfolio while in debt provides a much-needed ray of light. It is like your first day at the gym. You keep regretting all the sweets, and fried stuff that you ate. What you can now do is get on the treadmill and start the work-out!
PS: Did you know that your weight is a much larger function of what you eat and a small function of how much you burn?
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