There are two pieces of advice I constantly struggle to outrightly accept. The first is to eliminate as much of your debt as possible before moving onto other purchases or investments. The second is to save an emergency fund before making other purchases or investments.
On Eliminating Debt and Payments
Not everyone is good with debt. Some hate the idea of debt hanging over their heads. Others can’t stop using debt to make fast, instant gratification purchases. In both cases, the psychological impact of debt is likely better served by eliminating debt as much as possible.
But if you’re generally fine with the psychological state of debt and you can control your spending regardless of your cash capabilities, then debt is a tool to be utilized, not a weapon or a threat to be afraid of.
The key is to understand a net present value calculation. From Investopedia:
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
So, if the money made as a result of a purchase or investment made on debt are greater than the payments made on that debt, it’s wiser, in the long run, to make the purchase on debt.
Add in potentially tax deductible interest, wherein a purchase is made on debt and that purchase/investment is used to earn business, rental, or investment income, and the taxman now pays for 25% to 45% of the interest for you.
Again, if you can’t control yourself, there’s no positive NPV calculation that justifies a bad purchase.
But before assuming that debt is terrible, make sure the math behind the investment is completely understood.
On Saving an Emergency Fund Before Investing
We’re in a current emergency, and there are bound to be many people using the emergency funds they saved to get through these stressful times. I’m not anti-emergency-fund type of person.
What I am “anti” of is the idea of focusing on saving an emergency fund first and then investing later. The problem I have with this is quite simple: compound interest.
The longer a dollar is allowed to grow, the more powerful the exponential growth will be in the life of that dollar.
If you invest $1 today and let it grow at a presumed 8% rate for 40 years,1 it’ll be worth $21.72. If you take that same dollar and let it grow at 8% for 30 years, it’ll be worth $10.06.
It takes 30 years to make 10 times your initial investment, and only an additional 10 years to make 20 times your initial investment. And after 45 years? That investment will be worth $31.92 — 30 times your initial investment.
I’m not saying don’t save an emergency fund. By all means, having at least three months of living expenses in cash on hand is a healthy practice for everyone.
But I struggle with the idea of prioritizing the emergency fund over long-term saving. People need to begin long-term saving as fast as they possibly can — the exponential power is too great to ignore.
My general thought, at least at this point in time: If you’re able to save $100 every 2 weeks, split it 50/50 and dedicate one half to your emergency fund and one half to your long-term retirement savings. Or skew it in whichever direction makes you most comfortable.
But please, do not forget about the power of compounding.
Which is actually pretty reasonable, given the last hundred years of stock market history and average dividend rates. ↩