A few days ago, a friend and I were talking about filing this year’s taxes, and the conversation drifted to what to do with our returns. My friend asked a very common question:
Should I use my tax return to pay down debt or invest?
This is a pretty common question and one that can be generalized to “What should I do when I receive a lump sum of money? Pay down debt or invest?” I’ve already told you how to invest a lump sum of cash, but here let’s talk about how to decide between dumping debt or buying stock. Before I tell you the right way, let’s look at the conventional wisdom, because it’s wrong.
The Conventional Wisdom
Here’s what most people would say: compare the rates of return, and put your money on the higher one. If your credit card charges you 8% and you can invest at 11%, put your money in stocks. If your credit card charges a higher rate than you can earn by investing, then pay down the debt. Sounds good, right?
Wrong! If you play this game, you walk a dangerous line. So where does this way of thinking go wrong?
It disregards the element of risk.
A Better Approach
This comparison is not apples to apples. A credit card rate is pretty much guaranteed. Sure, it could go up or down, but only at the discretion of the credit card company. For our purposes, the credit card interest rate is guaranteed.
Stocks, like most investments, are inherently volatile. In the short-run, the rate of return from stocks is anything but guaranteed! In the long-run (20+ years) the stock market has averaged around 11%, but once again, this rate is not guaranteed.
Comparing the interest rate on stock investments to credit cards is comparing apples to oranges. A risky investment (stocks) versus a guaranteed obligation (credit cards). In order to compare apples to apples, we have to adjust the stock’s rate of return down.
Now, I’m pretty good with a financial calculator, but the formulas for adjusting for risk are a bit outside the scope of this blog and my mathematical skills. Suffice it to say, you will almost never find a guaranteed investment offering a higher return than what your credit card charges.
Let me say that again, because it is the point of this post: you will not find a guaranteed investment with a higher return than what your credit card charges.
So my advice to my friend (and to you) is to pay down debt before investing your tax return.
Unless you find a guaranteed 11%+ return. Then I’m all ears.