In the world of financial advice this is an age-old question, our version of “Are we alone?” or “Is There a God?” Seriously, it’s that important of a question (alright maybe not but roll with the intro here, alright?), particularly if you are a young adult with a newly minted diploma (or two) or the poor sap parent of a young adult with a newly minted diploma (or two). The proper answer to this question is ad-hoc, completely dependent on the individual in question. Anyone who says otherwise is a doctrinaire.
Compounding Interest and Investing
Of the unending variables and what-ifs involved in this question a few are worth noting and commenting on: 1) it is possible to create a hefty, if slightly abstract return on your debt by investing in it, 2) no one knows that the future holds when it comes to anything, much less the market, 3) compounding interest is the most powerful tool on any investors belt, and 4) eating is a biological necessity.
Getting a Return on Your Debt
As mentioned in other articles I have written, it is possible to get an abstract return on your debt in excess of 30%. The core ideology of the program is that by paying off debt aggressively and in full as early as possible one generates an increased cash flow. The increase in cash flow is generated through both interest expense savings and the gradual elimination of various types of debts. The increase in cash flow is the “return”. Its “abstract” in that you cannot cash out this return, as you could with a stock. This works. However by adhering to this type of program strictly one is forgoing all investing activity.
No one can predict the future; some just have a better track record than others. You aren’t Warren Buffet (who admits to some very costly mistakes) or Jim Cramer (who nearly bankrupted himself). In all likelihood you are at best the average-Joe investor, with no access to inside information, no connections in the wider industry of stock picking let alone the industries you may plan on investing in. The market’s historical average is roughly 7% when adjusted for inflation (1950-2009), 99% of investors can only hope to match that. Yet that return can be compounded, and that is when the returns explode. Albert Einstein, a pretty smart dude, called compounding interest the “most powerful force in the universe”.
My Own Philosophy
Now allow me to explain my own philosophy, carved out through my own experience, mistakes and research. I think, for those lucky enough to do so, that paying down debt aggressively while investing is the best road to financial freedom for young adults, while paying down debt aggressively only is the best option for their parents. For both groups, it all comes down to the annual debt to gross income ratio: your annual debt obligation (the total of your monthly payments extended by twelve) divided by your annual take home pay (income less taxes). This is an important cash flow measurement, and I love me some cash flow.
Low/Mid Income Adults: Rules of Thumb
A few rules of thumb for you young adults with next to no money left over after debt obligations and base expenses: if your annual debt to gross income ratio is less than 10%, you should be able to carve out some cash to invest. If the ratio is over 10% you should pay down debt as aggressively as possible until it is. Why do I say you should be able to carve out some cash to invest? Because nearly every young adult has an expense or two they can cut. Focus on the “needs”, not the “wants”. Honestly, if your diet doesn’t consist of 70% noodles, 10% Hamburger Helper and 20% Government Cheese you’re not trying hard enough. Don’t be a pansy. When your ratio falls below 10% invest the difference.
Remember, only you are in control of your debt to gross income ratio.
High Income Young Adults
If you are lucky enough to be a young adult with a newly minted diploma (or two) with income far in excess of the debt obligations you face (think a ratio below 5%), and have a good amount of money left over after all other base expenses, it may be best to set a plan that both aggressively pays down debt and invests. You have money left over at the end of the month; the people outlined in the above paragraph do not. As mentioned here, you have the opportunity to retire before your forty.
Parents and Older Adults
For you poor sap parents: you need to pay it down, get it off the books, especially if its student loans. Being far closer to retirement, your concerns should be different. Your discounted earnings potential is largely tapped, and retirement isn’t retirement if you still have debt hanging over your heads. Debt equals worry, and don’t we all deserve a worry free retirement, at least financially? One caveat, and young adult this applies to you too: if you have no emergency fund, however large, you need to concentrate on building one first. A good rule of thumb (yes, online financial advisers love them some rule of thumbs) is that your emergency fund should cover four-six months of base expenses, like basic food, rent and gas. Do not include your weekly golf outings or facials in this budget, in an emergency you won’t be attending.
Of course whenever you hear/read “rule of thumb”, or anything that is a gross generalization (like all the above) you should due the diligence and assess your own situation. The purpose of this blog is always to inform and incite thought, to be a starting point for your own financial savvy and maturity, not an online doctrine. However if you take this to be me leaving the door open for any poisonous and idiotic intellectual diarrhea you may be able to think up to justify your “wants” at the expense of your “needs” you need to stop reading this blog and begin the process of making friends with the other debt-laden, mentally weak, poor and unsecured morons in America. You won’t have trouble finding them.
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Other Amazing Snarkfinance articles:
 Simple Stock Investing, S&P 500: Total and Inflation Adjusted Historical Returns, http://www.simplestockinvesting.com/SP500-historical-real-total-returns.htm