Last Updated on December 2, 2024
Overview – Can Excessive Debt Prevent You From Being an Investor?
I’ve previously touched on the question of “is it possible to start investing too early?“, and the answer to this question was, yes: there are valid reasons a person may want to hold off on investing for now. Becoming an investor when you’re clearly not ready will only lead to big headaches down the road.
One of the reasons covered in that article is that a person may have an unstable financial situation, with one of the possibilities being that they have too much debt.
Love it or hate it, we inevitably come across or at least hear about debt during our lifetimes. Whether we’re buying coffee using a credit card or applying for a vehicle loan, there’s no denying that people all over the world use borrowed money on a regular basis.
Unfortunately, some people abuse this privilege of using borrowed money, and as a result, find themselves in a very precarious financial situation.
If you find yourself with an excessive amount of debt but have some cash lying around in your bank account, can you use that extra money for investment purposes to slowly reduce your debt while simultaneously building wealth?
Investing has the potential to greatly boost your finances, but the extent of its power is limited by an individual’s current financial situation.
A Quick Reminder on What Investing Is
Before we continue our discussion on why too much debt may prevent an individual from getting involved in investing, it’s important to remind ourselves what investing entails in the first place.
Although a thorough definition was given in a previous article, in very simple terms, investing is simply the act of putting money down today to get more money in the future.
When it comes to investing, the more money you put in, the more you get out of it. This is because investment returns scale: a 10% return on $1,000 is $100, but this same percentage return on $1,000,000 is $100,000.
It’s also important to remember that growing and maintaining an investment portfolio takes lots of time, energy, and patience. Sure, you can get lucky and find an investment that shoots up in value overnight, but being able to do this consistently is impossible – if it were possible to make money this easily, then every investor would be a billionaire.
There’s no such thing as an “easy path” to earning money, and investing is no different. At the end of the day, any sort of money-making endeavour, whether it’s a day job, a business, or your investment portfolio, will always require hard work.
Of course, there are things that people want (or sometimes need) but don’t have the funds available to pay for it all at once, or at least not right now. So, they borrow money to make these purchases.
It’s not unheard of for investors to borrow money for personal financial reasons, but there’s a major difference between having your debt under control and borrowing so much that it becomes too much to handle.
Manageable vs. Excessive Debt: How It Affects Your Investing Future
Imagine you have two people, Person A and Person B, who want to buy the latest and greatest iPhone. At the time of this writing, the iPhone that satisfies this criterion is the iPhone 13 Pro Max. Assuming they want the cream of the crop, the 1 TB model retails for $2,229 CAD (according to Apple’s website).
Since neither of them wants to spend that much cash up front, they both opt to use their credit cards for this purchase.
Person A is a 7-figure entrepreneur, earns well over $100,000 every month, and has more than enough money on hand to meet their day-to-day expenses. On the other hand, Person B works part-time, earns $2,000 a month, and consistently struggles to pay their bills on time.
Both opt to use debt to purchase their iPhones, but it’s clear that these two individuals handle the debt very differently. For one person, it’s very manageable, while for the other, it represents a major dent in their personal finances.
A person’s ability to manage their debt has a direct impact on their ability to become an investor or not.
This is because if you have your debt under control, then chances are it won’t hurt you financially to set aside some money for investment purposes. After all, you have sufficient money to meet your debt obligations, so there’s really no need to worry about not having enough funds on hand.
Excessive debt can impede your ability to become an investor because choosing to ignore your debt will only turn an already big headache into an even bigger one. This is primarily due to interest.
Every time you borrow money, there’s always an interest rate that comes with it. In today’s world, the type of interest used in the vast majority of scenarios is compound interest.
Compound interest is a double-edged sword: it works great when it benefits you (e.g., earning interest from a savings account), but it will quickly decimate your finances if used against you. The danger of compound interest is that it becomes bigger over time until eventually, it reaches a point where the interest owed exceeds the principal (i.e., the amount of money originally borrowed).
Sure, you can choose to become an investor despite having excessive debt, but your investment efforts will be in vain if you ultimately declare personal bankruptcy and creditors come and seize your assets, which includes whatever investments you may have.
No person has an infinite amount of money at their disposal, so common sense dictates that they prioritize which financial obligations deserve their money first. Excessive debt can quickly drain all your financial resources, so it would be best to make sure it’s brought under control right away.
But what if, despite all this, you still decide to start investing with the hopes that your investments will cover your debt. Is that possible?
Don’t Make the Mistake of Thinking Your Investments Will Cover All Your Debt
It’s easy to say to yourself “If I invest my money then my returns can easily cover all my debts, while at the same time leaving some money for me to pocket”.
This line of thinking, though optimistic, is wishful at best, and outright dangerous at worst. Remember: an investment portfolio takes time to develop and grow, it’s not something that will explode in value overnight unless you get extremely lucky and find an investment that rapidly shoots up in value in a matter of days.
Imagine you have $40,000 in credit card debt and only $5,000 in savings. Now, imagine that you decide to invest this $5,000. Even if your investments were to increase by 200%, their value would only be $10,000. Assuming you got really lucky and they went up by 300%, your investments would still be worth only $15,000.
Your $5,000 investment would need to grow 800% to pay for your debt, and this is only the principal amount: in the real world, compound interest would take that debt to astronomical heights, especially since virtually every credit card has double-digit annual percentage rates.
Any experienced investor knows that unless you happen to identify a once-in-a-lifetime superstar, no investment will experience triple-digit growth in a matter of days.
If you have excessive debt, then chances are your debt will grow faster due to compound interest than any investment you can get your hands on. It’s naive to think that a small amount of money will magically grow and eliminate your prodigious amounts of debt.
Although investors need to be optimistic that their investments will grow in the future, it’s important to ground these optimistic views with their current reality.
A young investor who has minimal debt and no major financial obligations has a valid reason to be optimistic about their investments’ growth. However, a young investor who is drowning in debt and also has lots of financial obligations needs to accept the reality that their investments probably won’t be able to save them.
Investing is very powerful, but only when done from a position of financial stability. You can’t expect your portfolio to grow if you’re constantly taking money out of it as you desperately try to make your interest payments on time.
Your Portfolio Can’t Grow if You’re Always Taking Money Out of It
Imagine you’re trying to grow a tomato plant in your garden. How do you get it to grow? By watering it, giving it fertilizer, and providing it with ample sunlight. If you’re constantly redirecting these resources to other plants, then it should come as no surprise that your tomato plant doesn’t grow as much as you originally hoped.
Investment portfolios are no different when you’re burdened with excessive debt.
Your portfolio will only grow if you regularly put money into it or if you reinvest whatever dividends or interest your portfolio earns. This growth isn’t possible if you’re constantly redirecting funds to pay for your debt, or worse, you take money from your investment earnings to pay your debt.
Excessive debt is a parasitic entity that will destroy your personal finances because it will consume whatever money you have, even if you’re already struggling to bring in enough money to begin with.
You can’t hope to establish an investment portfolio if you’re forced to constantly deal with a financial headache that only grows over time the more you leave it unsolved – compound interest will only make it harder to repay your debt the longer it remains unpaid.
Excessive debt is a major impediment to people who want to start investing because it will constantly drain your financial resources. The longer you leave excessive debt unpaid, the harder it will be to become an investor.
Wrapping Up
Most people need to borrow money to make purchases every now and then. Even if you have the funds needed to pay for something upfront, using borrowed money (most commonly your credit card) helps build your credit score, which will help you access low-interest loans in the future (such as a car loan or a mortgage).
While many people use borrowed money judiciously, problems start to arise when modest borrowing leads to excessive debt. One of the problems of having excessive debt is that it can impede your ability to start investing.
Remember that investing means putting money aside today to get more money in the future. This is a process that takes time, effort, and lots of patience – your portfolio won’t make you an overnight billionaire because no portfolio gains that much value that quickly.
Don’t fall for the false belief that your modest portfolio will be able to pay for your excessive debt. Chances are the compound interest earned on your debt will greatly exceed whatever returns you earn from your investments.
If you find yourself with lots of debt, it’s probably a good idea to get it under control before you even think about investing.
