It’s so nice when it happens. You receive an unexpected windfall, a tax refund, an inheritance … pennies from heaven.
But what do you do with it? If your financial condition is already healthy and in proper order you might consider giving a donation to a charity or individual who needs it more than you. However, if you aren’t independently wealthy you will want to use the windfall wisely for yourself.
If you have the will power to avoid spending it, the question becomes, “Do I pay down my current debt or do I invest this money?”
The question is based on an assumption most of us carry somewhere in our mental portfolio. We usually do not think of paying down debt as a form of investing. They’re both the same process at different places in the river.
Suppose you owe $1,000 and will pay 15% interest (or $150) per year. If you pay off the $1,000 you no longer owe the %15. You’re $150.00 ahead. You’ve “earned” $150!
On the other hand suppose you invest $1,000 and expect to earn 15% per year. Again, you’ve “earned” $150!
Unfortunately, the “system” rarely works as we wish. Let’s create a more realistic comparison.
Let’s suppose you have $10,000 with which you can pay down debt or invest. For realism, let’s pretend you’re paying 15% annual interest on your debt and, for this illustration, can reasonably expect to earn an annual return of 10% on your investment.
Here’s how it plays out over five years:
In Year 1, Your $10,000 investment will have grown to $11,000 and the debt you could have paid off will have grown to $11,500 for a net loss of $500.
In Year 2, Your $10,000 will have grown to $12,100 while the debt you could have paid off will have grown to $13,225 for a net loss of $1,125. It’s a slippery slope.
In Year 3, Your $10,000 will have grown to $13,310 while the debt you could have paid off will have grown to $15,208.75 for a net loss of $1,898.75.
In Year 4, Your $10,000 will have grown to $14,641 while the debt you could have paid off will have grown to $17,490.06 for a net loss of $2,849.06.
In Year 5, Your $10,000 will have grown to $16,105 while the debt you could have paid off will have grown to $20,113,57 for a net loss of $4,008.47. Ouch! The 5% difference between your debt’s APR and your investment’s return is painful.
How can you do this math really quickly and for longer terms? Use Wheatworks free Pay Down Debt or Invest Calculator. It’s available from our web site at http://www.wheatworks.com/freeware.htm and runs on Windows 95, 98, ME, NT4, 2000 and XP. Try it. We think you’ll like it!
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