Tax refunds can provide some discretionary funds. Should you spend it or invest it? During Financial Literacy Month, Managing Director Marilyn F. Booker outlines when to start investing and the power of compound interest.
As I travel the country teaching financial education, more often than not I hear people say that they are not ready to start investing. There are reasons to wait to invest, and there are reasons to start immediately.
But before you start investing, your financial house must be in order. That means you need a clear understanding of how much money you have coming in, how much you have going out, and how much is left over. Those remaining dollars, called “discretionary money,” are not committed to pay for mandatory expenses. Once you pay those mandatory expenses, many of which are likely to be recurring, then you must make wise decisions with your discretionary money that remains. This is especially relevant this time of year, when you might be expecting a tax refund.
So, what should you do with that discretionary money? Should you immediately start investing it? Well, it really depends. The first thing you must do is look at your debt and the interest rate you are paying on that debt. If you’re paying high, double-digit interest rates, then you should try to pay off that debt as soon as possible with your discretionary dollars. However, if your debt has low, single-digit interest rates, then you might want to invest those discretionary dollars instead.
Now, you might ask, “Why should I do this? Isn’t it better to just get rid of all debt?” The answer is, “not really.” You first must look at how well your investments might perform, or said another way, your rates of return.
Evaluate Investment Performance
One often-used measure of performance is the S&P 500 Index, a compilation/average value of the 500 largest publicly traded American companies. Over the last 10 years, the average S&P 500 return has been 6.8%.1 If you have debt that is costing you less than that 6.8%, then you are better off investing your money. That’s because you can potentially earn more by investing your money versus using it to pay off that low-interest debt.
To give you an example of this, let’s assume you have outstanding debt on which you are paying 4.0% interest annually. If you have investments that are keeping pace with the S&P average returns of 6.8%, then you are earning an extra 2.8% on your money, and you can use those extra earnings to pay down your debt (6.8%-4.0% = 2.8%).
Following me now? Good!
Now, here is the flip side: If you have debt that has an interest rate above 6.8%, you are losing money by investing. That is because, using the S&P 500 example, although you may be earning 6.8% interest on your money, you are paying out that 6.8% plus additional interest on that debt. Let’s assume you have an outstanding debt obligation on which you are paying 12.0% interest annually, and you have investments keeping pace with the S&P 500 average returns of 6.8%. In this example, you are paying out 5.2% more in interest than you are earning (12.0%-6.8% = 5.2%). So, you should pay down that high interest, then begin your investments. In short, you never want to pay out more than you are taking in or earning.
Assess Your Expenses
Now, what if, after you pay all your bills, you have no discretionary dollars left? Then you need to look at your bills and find the “excess”—that is, what bills have fat that can be trimmed. Is your cable bill too high? What is your cellphone bill? Why are your utility bills so high? Maybe you can cut back on a few entertainment expenses so your credit-card bill does not continue to grow.
This type of analysis is important, because having money left to save and invest after you’ve paid your monthly obligations is the only way to break the cycle of living from paycheck to paycheck. It is the only way to begin the cycle of saving and investing and to start having your money work for you!
Time is your friend...respect it! Once you have gotten your debt in check and your bills tamed so that you have discretionary dollars to invest, here is some food for thought: If you can save just $35 a week for 10 years and earn an average of 5% interest on that money, at the end of that 10 year-period you will have $23,600. And this is just by saving $35 a week!
Here’s another example: If you make a one-time investment of $10,000, assuming a rate of return of 8%, in 30 years you would have $100,627. In 50 years, you would have $469,016. Imagine what you would have if you could invest one lump sum of more than $10,000? Or what if you could add to that $10,000 over time? And what if you could earn an even higher rate of return?
But for this, you need time—time for that wonderful thing called compound interest to kick in. What that means is, for example, if you have $10,000 and your rate of return is 8%, after the first year you will have earned $800 and have $10,800. The next year, if your rate of return is again 8%, you will have earned 8% on $10,800, or $864, and have $11,664 at the end of that year second year. And so on.
This is what earning money on your money on your money looks like. But you need time for that money to keep growing like that. You have to make the right moves to put yourself in the position to, as soon as possible, begin assembling your financial masterpiece. Don’t squander valuable time.
You are the master painter of your financial portrait. The brush strokes you take will determine the beauty of your picture. Take control of that brush, paint the strokes and allow time to do the rest for you.
1Past performance does not guarantee future performance of any investment instrument. This representation was used for illustrative purposes.