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Paying off high-cost consumer debt

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Paying down debts isn’t nearly as exciting as investing, but it can make your investment decisions less difficult. Rather than spending your time investigating specific investments, paying off your debts with money you’ve saved may indeed be your best investment.

Consumer debt includes borrowing on credit cards, auto loans, and the like, which are often costly ways to borrow. Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business, because consumer loans are the riskiest type of loans for a lender. Risk means the chance of the borrower’s defaulting and being unable to pay back all that they borrowed.

Many folks have credit card debt that costs 18 percent or more per year in interest. Some credit cards levy interest rates well above 20 percent if you make a late payment or two. Reducing and eventually eliminating this debt with your savings is like putting your money in an investment with a guaranteed tax-free return equal to the rate that you pay on your debt.

For example, if you have outstanding credit card debt at 18 percent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 18 percent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you would need to earn more than 18 percent by investing your money elsewhere to net 18 percent after paying taxes. Earning such high investing returns is highly unlikely, and to earn those returns, you’d be forced to take great risk.

Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or general ability to save and invest) because it encourages you to borrow against your future earnings. People say such things as “I can’t afford to buy a new car for cash, given how expensive new cars are.” Well, okay. New cars are expensive, so you need to set your sights lower and buy a good used car that you can afford. You can then invest the money that you’d otherwise spend on your auto loan.

Investing All-in-One For Dummies

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