It's a good question – if you have debt, does it make sense to invest? Although you may think the answer is simple, often it won't be.
You may have heard of the quote often attributed to Albert Einstein: "compound interest is the eighth wonder of the world… he who understands it, earns it; he who doesn't, pays it."
By investing in shares, you are opening yourself up to earning compound interest (if you pick the right shares), so it's a good start. But for this to work, you have to make sure you aren't paying someone else's compound interest first. Debt and investing are the mirror images of each other, one works in your favour, making you money at an accelerating rate, while the other takes money from you at the same (or often higher) rate.
There is a reason why a bank like Westpac Banking Corp (ASX: WBC) sends you letters offering you a higher credit card limit or a 'handy' personal loan – Westpac wants to make compound interest from you! If you understand this, then you will never look at debt the same way. Ask yourself if you should have a Westpac loan, or Westpac shares…
Good debt vs. bad debt
Debt is not black and white – there is good debt and bad debt. A loan for an asset that will (hopefully) appreciate in value, such as shares, a house or a business, can be mutually beneficial – the bank makes a profit and you get an appreciating asset for a fixed loan. Maybe you have a HECs debt for studies that you have used (or will use) to increase your skills and future earnings potential. These kinds of debt can be viewed in a positive light as they put more cash in your pocket than they take out
Borrowing money for a car, holiday, or the newest iPhone might feel good at the time, but only serves to line somebody else's pocket at the end of the day, usually with a pretty nasty interest rate. This kind of debt is bad debt and if you have any, paying it off should be your priority before you consider any kind of investing. And yes, this includes using Afterpay Touch Group Ltd (ASX: APT).
Foolish takeaway
If you are bad debt free, you are ready to see the wonders of compound interest work in your favour. Strong dividend-paying shares like Australian Foundation Investment Co.Ltd. (ASX: AFI) are a great place to start, because dividend-reinvestment programs are a great example of compound interest at work.
Today, ask yourself – are you earning or paying compound interest?
