Financial Learning Center


Debt is something of a double-edged sword. On one hand, it offers you ability to buy something that would normally be out of reach financially and allow you to pay for it over time. But on the opposite side, debt comes with a cost. You are borrowing someone else’s money, and for that privilege, you need to pay money.

So when is debt too costly? If you have extra money on hand, when does it make more sense to pay off debt, and when does it make sense invest the money instead?

Well... It all depends on interest rates.

The line between bad debt and good debt depends entirely on how expensive that debt is.  And the higher the interest rate on the debt is, the more expensive it is to hold. So debt that is considered bad, should be paid down, and if it is considered good debt, then the urgency to pay it down is lower.

So what is the dividing line between good debt and bad debt? A quick answer to that question is to say that right now, 6% or 7% is the dividing line between good debt and bad debt. But the issue is not as clear-cut as that. There are a lot of grey areas,

Instead, you should ask yourself if you should pay down your debt, or whether there is something “better” that you can do with your money? So instead of paying down your debt, is it a better idea to invest your spare cash?

To make that decision, you have to look at what kind of returns you can get from investing your money.  If the returns you can get from investments are higher than the interest you pay on your debt, then investing your money may be a better option.

So what kind of return can you get from investing? That’s a big question. Historically, average annual returns of from the US stock market (including from dividends) has been around 11%. We’ll note here that this number is debatable, and depends on the time-line you use and how you measure “the stock market”. But over the long run, US equities have generated handsome returns.

But for the sake of argument, let’s temper our expectation of returns. Let’s say we are conservative investors and expect a 6% return. Let’s see how that impacts your decision about paying down debt.

Historically, credit card debt has carried a double-digit interest rate. Average rates hover around 15% and penalty rates can be as high 29%.

Let’s assume your credit card interest rate is 15% and you have an extra $100 that you can use to pay down the money you owe on your credit card. If you pay down your principle by that $100, it means over the next year, you would have saved the 15% interest that would have been charged on that $100, which would be $15.

If you instead took that $100, and invested it, and everything went according to plan and you earned a 7% return, you would have made $7. So you’re $7 richer than when you started. But remember that you didn’t pay down your credit card debt. So you paid $15 in interest you could have avoided had you paid down your credit card debt. So in this case, you’re $8 worse off than if you had paid down your credit card debt.

Any way you look at credit card debt, it is almost always better to pay down this high interest debt than it is to invest. There will be some years where stock market will preform above expectations, and will give you better returns than paying down your credit card. But these are definitely the exception, and over the long run, paying down credit card debt is the better option than putting that money into investments.

On the opposite end of the debt scale are mortgages. Because they are backed by the value of a house, they tend to be lower risk for the lender and offer some of the lowest interest rates of any debt. In this case, the savings you get from paying down an average mortgage is usually lower than the gains you get on an average year of investing. Again we say “average” because in some years this will not be the case. But over the 20 or 30-year span of a mortgage, it wouldn’t make sense to stay away from investing while you pay extra on your mortgage. (You should still always pay your monthly payments though!).

While the logic of paying down debt is clear on both extremes of interest rates, the logic is much less clear when the interest rate is somewhere in the middle. There are no rules when it comes to making decisions about debt with moderate interest rates. So here are some guidelines.

  1. Check your gut. Look at how well you tolerate risk. If you can stomach the ups and downs of a bumpy stock market, then maybe investing your extra money in the stock market is a good idea. On the other hand, if a bumpy stock market will cause you undue stress, then paying down your moderate interest debt may be a better idea for you.
  2. Go you like guarantees? The savings you make by paying off your mortgage are guaranteed savings. You know that if you pay down your debt, you will save money. There are no such guarantees in investing.
  3. What does the future look like? If the market is in turmoil, or there is economic uncertainty on the horizon, think twice about putting more money into investments. Paying down moderate interest debt might be a better option.

Here’s an important note for people carrying student loan debt. If the interest rate on your loan is low, and you can manage the payments easily in your monthly budget, try to prioritize saving and investing. Starting investing early can have a huge impact on your future financial success.

Finally, remember that there are no guarantees with the stock market. There is no way to predict which way the market will go in the future. So there is no guarantee that investing in the stock market will get you a better return than paying down any debt. The stock market can (and does) go down. All you can say is that the historical odds are in your favor over the long run. So if you do decide to use your spare cash to invest, make sure it is for the long run so you can ride out the bumps.

You can borrow money to buy just about anything big or small. You can use a mortgage to buy a home or a credit card to buy a coffee, a home equity loan to build a deck or a student loan to get an education. There are loans available for every purpose.

What about with investing? Can you borrow money to buy a stock? Well yes, most brokerages will lend you money to buy investments. This is called ‘margin lending.’

A margin account is an account offered by brokerages that allows clients to buy securities using money borrowed from the broker. The broker charges interest on the borrowed money and uses the investment as collateral on the loan. Because the loan is backed by a security, it is seen as lower risk than if there is no collateral held against the loan. So the interest rates charged on margin account is generally modest.

The interest rate charged on margin accounts can vary, and it usually depends on how much money you have in your account. Large accounts (those around a million dollars) can have rates that are very low and are comparable to mortgages. Smaller accounts will have rates that are higher, and can be up to 8%.

So how does a margin account work? Let’s look at an example. Let’s start with a trade that does not use a margin account.

Let’s say you have $5,000 to invest. Let’s also say that you love company X, whose shares are trading at $100. So on January 1st, you buy 50 shares of X, using all your $5,000. At the end of the year, X is trading at $150, so you sell all your shares and get $7,500. So over that year you made $2,500 on your investment, or a 50% profit.

Now let’s look at the same trade but using margin this time. Let’s say you still bought those 50 shares at $100. But you love X so much that you borrow $5,000 on margin to buy another 50 shares. Now you own 100 shares of X. Again, at the end of the year you sell all your share, this time 100 of them at $150 thereby getting $15,000 on the sale. Now you have to pay back the $5,000 you borrowed. You’ll also have paid about $300 in interest on the borrowed money over the year. So you’re left with $9,700. On this trade, by using margin, you made a $4,700 for a profit of 94%.

Terrific right!? Well, not so fast.

What happens if your stock goes down? What happens then?

Let’s look at the same trade but instead of going up to $150, X goes down to $50 at the end of the year. Without using margin, you would sell your 50 shares for $2,500. That’s a loss of $2,500 for a net loss of 50%.

Now let’s look at that same scenario using margin. If you sell your 100 shares at $50, you will get $5,000 in proceeds. But you owe your broker the $5,000 that you borrowed, plus the $400 in interest. So not only do you owe your broker all of the money you have in your account, but you would have paid another $400 in interest on the loan! On this trade you lost $5,400 for a net loss of 108%! Ouch!

As you can see, margin can be very dangerous. When your investment goes the wrong way, you can lose a significant amount of money.

The Federal Reserve Board understands this and has put rules in place to prevent excessive loss while using margin. They do this in two ways. The first is by setting an initial minimum margin of 50%. This means that only 50% of your purchase of a stock can be purchased using margin. So in the above example, the trade would be allowed because only 50 of the 100 shares were purchased using margin.  It should also be noted that some brokers require higher initial margin requirements, but the legal minimum is 50%.

The second requirement is a maintenance margin of 25%. Maintenance margin refers to the amount of investor’s equity (what the investor owns outright) as a percentage of the market value of the holdings. In our above example, the account would have a maintenance margin of 25% when the stock hit $66.66. When this happens, the  value the holdings would be $6,666, but because the investor owes $5,000 for the loan, the actual value of what he owns is only $1,666, or 25% of the balance. When the account value dropped to $6,666, the broker would have contacted the client to ask him to put more money into the account. This is called a margin call. It’s a dreaded occurrence and one every investor who uses margin lending fears.

You should note something interesting here. In the example we used, our investor who used margin and whose stock dropped to $50 would have gotten a margin call when the stock hit $66.66. So although he loses a tremendous amount of money, he is not completely wiped out.

But you should also notice what didn’t happen. The broker didn’t lose money. The margin call made sure that the broker got their loan back. And to make sure they get their money, under the rules of a margin account, the broker can sell your shares without your permission. They have considerable power to get their money back.

So it should be fairly obvious that the margin rules are not there to protect you from excessive loss. They are there to there to protect the broker from any loss.

Now after scaring you out of opening a margin account, there are times when margin is a good thing to have. Borrowing money for very short periods of time is a good way to use margin. For example, if you are waiting for money to transfer into your brokerage account and it isn’t there yet, you can use margin to buy a stock you want. Or sometimes when you sell a stock, it takes a few days for the trade to clear and for the money to reach your account. Again, if you want to use margin for the two days it takes your trade to clear, this is a good use of margin.

But remember, the longer you employ margin, the greater the danger it is to you. Every day you use margin, the more interest you will be charged and the more gains you will need in order for you to make up the interest payments.

So try to keep the use of margin to a minimum, and if you do use it, only do so for very short periods of time.

The great economies of the world have been built on peer to peer lending. It’s what people have done for millennia: You take your money and lend it (with interest) to family, friends or the community, to create value for yourself and for them.

There are two different ways to think about this.

There are probably many in your circle of family and friends who may need money at some point in time. They will ask to borrow money from you, maybe with regular payments and fixed interest. But this is not putting your money to work.  This is helping your family & friends, and it’s a fraught process. If you’re in a position to gift money (i.e. you have a fully funded retirement account, emergency savings and are living well below your income) – then consider it. But there’s a chance you’ll never see the money again. So if you do it, make sure you consider it a gift.

The second way to put your money to work by lending it to others is through ‘peer to peer’ lending. This is where you deposit your money with an intermediary, who then lends it out to people who need it. It’s very similar to the traditional way that banks work. But with a big difference – you get visibility into where your money is going. With some lenders you can see where your loan is going. You also get to choose the amount of risk you want to take, and what return you are looking for.

Prosper, SoFi and Lending Club are all peer to peer lending companies where you can deposit your money, which is then loaned out for higher interest rates than what you can get with your savings account at a regular bank.

So is it a good idea for you?

The first thing to consider is risk. When you put your money in a savings account, it’s insured by the FDIC for up to $250,000. So if the bank goes out of business, you won’t lose your money.

Funds with P2P lenders are not insured – so should there be issues with the financial stability of the lender, there’s a chance you could lose your money. So consider where you are on the spectrum of risk tolerance and see if this is money you can afford to lose.

Next thing to consider is performance.

The relationship between risk & return is what investing is all about. The stock market and P2P lenders are both higher risk / higher potential return. Currently the estimated returns from P2P loans are between 5-8% per year. This is significantly higher than what you can get in a regular savings account, and on par, over the past few years, with what you would have gotten in the stock market. But as with all investments, there is no guarantee of returns.

Third thing to consider is ethics.

For many borrowers, P2P loans are a godsend. If you’re consolidating high interest credit card debt for example, going from paying 20+% interest to 8% is pretty great.

But in order for these platforms to give high returns to investors, they also charge high penalties – such as late fees. It can happen that borrowers get trapped in these loans. It’s estimated that 70 percent of those who consolidate their debt end up with as much or more debt a few years later. So the benefits of these loans may have strings attached for the borrowers. And as a lender you have to make sure you are comfortable lending your money into this system.

Lending money doesn’t usually get included in recommendations by financial advisors. It’s an interesting and unique investing option. But doing so involves risk.

Think carefully about putting your money to work by lending it to others. Understand the risks involved. But if you enter this market, also enjoy the fact that you can direct your money to specific areas of specific need. It really can be a rewarding way of investing.

Compounding is your friend. And if you’re serious about investing, it is your best friend.

Compounding takes average investment returns and kicks them up a notch. Here is the basic premise in a simple question. Would you like to get a penny today and have it doubled every day for a month, or would you like to get $10,000 dollars per day for a month? If you picked the penny, you’ve understood the power of compounding. And it’s not even close. After 30 days, your $10,000 a day plan would earn you $300,000. The penny strategy is essentially 100% daily interest compounded daily, which would earn you $5.3 million dollars by the 30th day! Sweet!

Compounding is essentially a way to accelerate the growth your investments by earning interest on the interest you’ve already earned. The difference between compounded earnings and non-compounded earnings is substantial. Let’s look at an example. Take a $1,000 bond paying 4% interest. Without compounding that money doubles after 25 years. With compounding, the money doubles after 18 years. That’s seven years sooner! That’s a big difference!

To calculate the impact of compounding, a super-simple method is the Rule of 72. All you do is take 72 and divide it by the interest rate.  The result will give you the number of years it will take to double your money. So at a 12% interest rate your money will double in six years (72 divided by 12).  Super easy!

The key to compounding is to make sure interest is reinvested. Interest bearing savings accounts automatically add interest back into the same account. Some bonds add interest to the principal owed and compound future interest payments automatically until the bond is paid out. But many bonds, like US Treasury Notes and Treasury Bonds, pay interest out directly to you every six months. Unless you reinvest the interest yourself, you will not get the compounding benefit.

You can also use the power of compounding with stocks. If you get a dividend or cash out a stock for a gain, you can reinvest the earnings back into another investment. Many 401(k)s and mutual funds have an ability to do this automatically through a dividend reinvestment option. Find out if they are available and make sure you use them!

So make sure you harness the power of compounding. It will accelerate your earnings and help you get to your financial goals more quickly.

Putting the money you have to work through investing is a side hustle that you can do while you’re working hard at your regular job. As the sad cliché goes: “no one ever got rich through their salary.” The point being that equity – in real estate, your investment portfolio or businesses, is the key to long-term financial success.

You work hard for your money. Make it work hard for you.

In the US and in many countries, investment income is taxed at a much lower rate than your salary is. Which is why the 1% (aka the very rich) probably pay a lower tax rate than you do. The higher the percentage of your income that is investment income, the lower the overall percentage of tax that you pay.

Remember, if the value of your portfolio goes up, that is not income. Not unless you sell some or all of it, and realize the gain.

Investment income comes in the form of dividends (from companies), interest (from bonds) and capital gains (from the sale of investments that have increased in value).

If you plan on tapping into your investments to take our some income, you should do some math to figure out what that means. Let’s say you have a $500,000 nest egg. At a conservative 4% return from interest, dividends and capital gains, that will amount to only $20,000 in potential income per year. That’s not a huge income, at least not one you can live off of.

The key to investing is to not take out much income, but rather reinvest your earnings. This compounding effect, where you make money on the gains you’ve already made, is the key to generating substantial savings. By taking out some of the gains as income, you put a big dent into your ability to grow your nest egg.

The goal of investing is usually to grow and reinvest your gains until you retire. If you do this, you will maximize the size of your retirement fund and will buy you options later in life. And when you retire and have no income, you can then draw an income from a much more sizable pool of savings.

But you can find sizable income streams from other types of investments. Investments such as real estate, or investing in a small business can also create income. Just make sure you have contingency funds in case the income doesn’t come immediately, or if problems arise (for example, investing in a rental property that stays vacant for a year).

So the answer is yes, investing can be a second income if that is your goal, but the key thought is that in the longer term, multiple income streams can build your savings and buy you future options in life. Investing your time, attention and money in more avenues than just your primary career, is a great way to ensure that your net worth can grow.

It’s a big part of the American dream – owning your own home. We’re hardwired to believe that it’s something we ‘should’ do as an adult, especially when you have a family.

And with what seems like skyrocketing prices in places like New York and San Francisco, it’s easy to believe that real estate is a great investment.

Let’s take a few steps back and consider if real estate is a good investment for you.

Firstly, buying your own home is not really an investment. It’s an asset. You live there because you love your home, not because it’s a good investment. You need to live somewhere, and if the value of your home goes up, great. But for now, let’s take your primary residence out of the ‘investment’ discussion.

There are a few different ways to invest in real estate. The most common is to buy a second property (either residential or commercial) and rent it out. 

You can also be a ‘part owner’ of a property – like a time-share vacation property.

Or, you can invest in REITs – Real Estate Investment Trusts, where you buy shares in a fund that invests in multiple properties. REITs are traded on the stock market. There’s a dizzying list of them here.

Now, let’s do the math on the different options.

When you buy a rental property as an investment it’s essential that you understand the true costs. If you think you can get $20,000 a year in rental income – make sure the other side of the balance sheet is lower (including mortgage payments, maintenance costs, broker fees, real estate taxes and insurance). Many people are surprised that the costs of running a property can be as much as 50% of the mortgage costs. So make sure that before your buy, you know that you can really afford the investment.

As a benchmark, the average return on real estate is 4% a year. As a comparison, the historic average return of the US stock market has been 7%, or 11% if you include dividends. So if you’re playing the averages, investing in stocks has had a better track record than real estate.

There are some added benefits to investing in property. For one, you may qualify for tax deductions especially if you buy it as an LLC (this is where you start a limited liability company and process the income and costs as a business instead of as an individual). The biggest tax benefit is the ability to deduct the depreciation of the property on your taxes.  However, tax optimization is not the main reason to buy a property.

A time-share property will most likely make a lower return than owning it outright, but you have the benefit of not having to manage the property or find renters. A management agent will do that for you (and take a percentage of your revenue as their fee). Think of them this way - you’re putting up real money, taking real risk, and getting a fraction of the return for the benefit of fractional ownership.

The math on REITs is much simpler. You can buy a share in a REIT for as little as $60. If you really want to just dip a toe into the property market without taking on huge risk of owning an actual property, REITS are worth considering.

Property is emotional. But investing in property needs to be all about the math PLUS the effort and time you will take in managing it. Here’s a short list of things to consider before you pull the trigger on a real estate investment.

  1. Real estate isn’t a get rich quick environment – despite what the many home flipper TV shows may say.
  2. Just because prices are going up now doesn’t mean that they always will. The Great Recession showed us the pain a falling housing market can inflict.
  3. You need to be prepared to do due diligence – on both the property, and your future tenants.
  4. You need to forecast an accurate cash flow, and have a contingency plan in place in case the property stays vacant longer than you expect.
  5. You need to forecast how much time you will need to dedicate to this investment, or how much you will pay an agent to do the work on your behalf.
  6. You need to have great insurance and a ‘what can go wrong, will probably go wrong’ attitude.
  7. You really shouldn’t figure it out as you go. Really understand what it means to own property from a cost and liability perspective.
  8. Always start with the end in mind. Are you buying this for purely financial reasons and you can sell when the time is right? Or is it a property that you may want to live in, or start a business in, later in your life – have a clear vision for WHY you’re doing this.
  9. Houses are not stocks. You can’t sell them with a click of a mouse. They take time, and money to sell. Don’t be in a hurry if you want to sell a house.
  10. When housing markets are going up, sellers are in control. When the market falls, buyers are in control. If you can find one. Don’t be on the wrong side of the market.
  11. There are high transaction costs associated with property. Commissions, fees and taxes can add to the cost of buying and selling property. For this reason, short-term profits are extremely hard to come by. You need to be thinking a long-term game with property.

In the end, property can still be a terrific investment. It has been the foundation for many people’s security and wealth, and it may well be for you too. Just make sure you understand the risks, not just the returns.