Investing is one of the best ways to build wealth, yet rising household debt levels could stand in the way of the investment dreams of most Americans.
According to the latest Quarterly Report on Household Debt and Credit from the Federal Reserve Bank of New York’s Center for Microeconomic Data, Americans owe more than $16.15 trillion. That’s an increase of 2% from the previous year, adding another $312 billion to consumers’ collective IOU.
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Of the types of debt included by the Federal Reserve — some of which include mortgages, personal loans, and revolving home equity — it was credit card balances that saw the most impressive growth. Households increased their credit card debt by 15% year-over-year, the largest increase in more than two decades.
People have taken on more debt in the past year as inflation runs hot. While economic forecasts suggest it will cool off in the coming year, it currently remains well above the central bank’s preferred benchmark.
The financial situation faced by many Americans has left some people confused about their options. Many popular financial pundits — among them, Dave Ramsey and Suze Orman — recommend stomping out debt before anyone invests.
While their advice can help those buried by credit card or line of credit debt, following this rule universally would preclude roughly 80% of Americans from investing — that’s how much of the country is predicted to carry debt.
Compound Earnings vs Compound Interest and the Minimum Payment
“I started building this little snowball at the top of a very long hill. The trick to have a very long hill is either starting very young or living to be very old.”
Following Buffett’s metaphor, the longer the hill is, the more time a snowball has to pick up momentum and collect snow along the way down. In other words, you’ll watch your investments grow bigger and bigger the earlier you start.
His advice joins other market experts who suggest investing for the future, even if you have debt. If you wait, you lose a key part of the equation: interest + time. Investing earlier means you have more opportunities to earn interest, reinvest your returns, and drive up the value of your investments.
While this is broadly accepted as actionable advice, things get complicated when you compare compounding returns to compounding interest, particularly in credit cards and lines of credit. These revolving accounts grow momentum much like investments, but rather than earning more money, consumers owe more.
This can happen when relying on the minimum payment. The minimum payment indicates the smallest amount of money credit card holders must pay to remain current on their account.
Any month a consumer relies on the minimum, they will carry over a balance that’s subject to interest and fees. These fees roll into the amount owed in the next billing statement and will be subject to interest and fees should they rely on the minimum again. This cycle increases what the credit card holder owes — even if they have a low APR, and even if they don’t use their credit card ever again.
Simple math shows people who only ever pay their minimums will take longer to pay off debt and pay more interest as a result. That’s because the minimum has the power to take a modest balance and turn it into a substantial debt. In some cases, interest could outpace the earnings on investments.
Interest is why personal finance personality Dave Ramsey recommends paying off debt first before moving on to investments. And for those stuck paying only the minimum, this is great advice. Consumers who rely on minimum payments should follow a budgeting guide to see how they can maximize their monthly payments to avoid accruing interest.
However, his advice fails to consider other loans and consumer habits.
According to the National Bureau of Economic Research, 29% of consumers regularly make payments at or near the minimum payment. The study found that those relying on the minimum do so because they can’t afford to pay more.
Cash flow, rather than debt alone, should be an indicator of one’s ability to invest. After all, those who consistently pay more than the minimum have liquidity, and they won’t carry debt for long enough to amass mountainous interest.
Some term loans also calculate the cost of compounding interest at the start, so every payment already has this interest included. Consumers won’t save money in interest by paying off a short-term personal loan early if it follows this price breakdown. Other term loans may come with 0% APR, meaning these lucky borrowers won’t earn any interest, regardless of how fast or slow they pay off their debt.
Evaluating Return on Investment vs Cost of Borrowing
A more nuanced approach is critical to the long-term financial health of Americans. You need a macro look at your finances that considers debt type, APR, your debt-to-income ratio, and how your return on investment (ROI) compares to the cost of borrowing.
It may be financially sound to continue investing while in debt, provided you have the cash flow to handle both responsibilities, and your ROI exceeds your cost of borrowing. Other reasons to invest despite debt include whether your employer matches your 401(k), or you generate passive income that outweighs your cost of borrowing.
A Bear Market and the Bank and Credit Services Industry
Like the average American, the markets have experienced a year of shock and growing uncertainty, with 2022 being the Street’s worst year since 2008. Last year doled out massive losses for most indexes and investments. The Dow fell by 8.8%, the S&P 500 dropped 19.4%, and the Nasdaq, ladened by technology firms, plunged by 33.1%.
Inflation and the central bank’s steep rate hikes translated into a tough year for the bank sector and credit services industry despite rising debt levels. It’s not unusual for bank loan losses to rise and capital ratios to fall during bear markets and broader economic downturns.
Market valuations for financial institutions dropped as a result — whether they were household names such as Citigroup (NYSE:C) and Bank of America (NYSE:BAC) or emerging FinTech brands like Propel Holdings Inc (TSE:PRL).
With low bank and credit service valuations, investors can add these undervalued stocks to their portfolios for an attractive price.
If history is a guide, the bank sector and credit services industry will make a full recovery as the economy levels out. For now, buying financial stocks when they’re trading at their lowest valuation in decades could help investors pull in better returns.
To borrow from Buffet’s language once again, this technique allows investors to increase the time their snowball has to roll down the hill.
Generic financial advice can appeal to a lot of people, but it doesn’t work for personal finance — because it’s very personal.
No two situations are alike. Someone who carries a large debt load in what is considered “good debt” is not equal to someone with comparatively little “bad” credit card debt who relies on minimum payments. Prescribing the same investment strategy for both fails to consider these nuances.
While some people might feel overwhelmed by their debt, others take a long-term approach to their finances. They budget so that they can invest while repaying what they owe, so they can maximize the time they have to compound returns.
Adhering strictly to the idea that no one with debt can trade or invest doesn’t just prohibit 80% of the country from investing. Waiting to pay off debt first could also cost investors the opportunity of purchasing undervalued stocks before they attain their intrinsic value.
Knowing when to follow and when to break the rules as they relate to your personal situation can help you take positive measures to protect your long-term financial future.