How to Invest When You’re Deep in Debt

It’s natural that if you have some money saved or invested, you want to see it grow over time. There are many factors that can prevent this from happening, but for many people, one of the biggest obstacles is debt. If you have a sizable amount of debt to deal with – be it a mortgage, line of credit, student loan or credit card – fear not; you can still learn how to balance your debt with saving and investing.

What Are the Different Types of Debt?

Generally speaking, having debt can make it very difficult for investors to make money. In some cases, investing while in debt is like trying to bail out a sinking ship with a coffee cup. In other words, if you have a debt on your line of credit at seven percent interest, the money you are investing will have to make more than seven percent — after factoring in taxes and fees — to make it more profitable than simply paying down the debt. There are investments that deliver such high returns, but you have to be able to find them, knowing you are under the burden of debt.

It is important to briefly distinguish between the different kinds of debt that may be incurred:

High-Interest Debt

This is your credit card. High interest is relative, but anything above ten percent is a good candidate for this category. Carrying any kind of balance on your credit card or similar high-interest vehicle makes paying it down a priority before starting to invest.

Low-Interest Debt

This type of low-interest debt may often be a car loan, a line of credit or a personal loan from a bank. The interest rates are usually described as prime plus or minus 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 percent than one that has to return 25 percent.

Tax-Deductible Debt

If there is such a thing as good debt, this is it. Tax-deductible debts include mortgages, student loans, business loans, investment loans and all the other loans in which interest paid is returned to you in the form of tax deductions. Since this debt is generally low interest as well, you can easily build a portfolio while paying it down.

The types of debt we will focus on in this article are long-term low-interest and tax-deductible debt (such as 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 likely want to focus on paying it off before you begin your investing adventure.

Using Compounding to Grow Your Money

Debt elimination, particularly of something such as a loan that will take the long-term capital, robs you of time and money. In the long term, the time (in terms of compounding time of your investment) 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 for as much time as possible to compound. This is one of the reasons to start a portfolio in spite of carrying 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.

Creating a Plan to Invest

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 the place of low-risk and/or fixed-income investments. This means that you will be seeing “returns” from the lessening of your debt load and interest payments rather than the two to eight percent return on a bond or similar investment.

The rest of your portfolio should focus on higher-risk, high-return investments like stocks. If your risk tolerance is very low, the bulk of your investing money will still be going toward 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 with most of your money being “invested” in your loans and only a little going into your high-risk and return investments. As the debt gets smaller, you can adjust your distributions accordingly.

The Bottom Line

You can invest in spite of debt. The important question is whether or not you should. The answer to this question is very personalized to your financial situation and risk tolerance. There are certainly benefits from getting your money into the market as soon as possible, but there is also no guarantee that your portfolio will perform as expected. These things depend on your investing strategy and market timing.

The biggest benefit of investing while in debt is psychological — as much of finance is. 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 begin.

Debt becomes like a limbo state where things seem to be happening in slow motion. By having even a modest portfolio to track, you can keep your enthusiasm about the growth of your personal finances from ebbing. Knowing that the sun will come up and be 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.

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