Let’s say you have been carrying balances on your credit cards to the tune of $30,000. Then you get a windfall amounting to $30,000. Do you pay off your credit card or invest in stocks?
The answer is that it is almost always better to pay off your credit card than invest in stocks
Stock investing returns
When you buy stock through a brokerage, you are buying a tiny ownership percentage in a company. If the stock rises, your investment is worth more. So if you buy 1000 shares of Bob’s Widgets Inc. at $30 per share, and one year later it is at $36, you have made a 20% return on your stock investment.
You may even receive a dividend payment for owning the stock, which might run from 0.5% to even 10% or more, depending on the stock.
But all this comes with risk. You do not know if the stock will go up or down. You don’t know if you will make money or lose money.
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Credit card payoff return
If you pay off your credit card and not invest in stocks, you will get a guaranteed return on that money, equal to the card’s interest APR. That’s because every dollar you use to pay down the outstanding balance results in an interest savings, which is considered a return on your investment.
So if you are carrying $30,000 in credit card balances and paying 14% APR, then you are effectively earning 14% on your money, because that is what you save in interest.
Some savvy readers may ask, “Wait a second. If I pay off the credit card and not invest in stocks, aren’t I giving up a possible return in stocks, since I could be using that money to invest?” Yes, you are. That is called “opportunity cost.” However, you don’t know the exact opportunity cost of not investing because, well, you didn’t invest!
The only way to measure opportunity cost is to either invest in something where the principal doesn’t change but you get paid a fixed dividend or interest (usually bonds, or preferred stocks), or if you name a specific investment you would have used the money for and checked to see how it performed one year later.
There’s a tax issue that also makes it better to pay off your credit card instead of investing in stocks. If you make money on stocks, one day you are likely to sell those investments and owe capital gains tax, which can run anywhere from 15% to 40%. The same goes for dividends.
So that reduces your overall return. A 20% stock return may end up only being 12% to 17%, after taxes.
Paying off a credit card, however, incurs no tax liability.
There’s really only one exception to this rule, and even that is dicey, and only undertaken by very savvy investors.
Most APRs are going to be over 10%, and as high as 25%. You are very unlikely to get an after-tax return that high to make the stock investment worthwhile.
However, if your APR is incredibly low — say, 0% to 4% — then there are certain bonds, exchange-traded debt, and preferred stocks where your principal isn’t going to fluctuate much, but you can earn 7% on up to 10% on your money, pre-tax.
That might result in a small profit.
Still, the total amount you make isn’t going to be that much and likely is not worth the risk.
Bull and bear image via Shutterstock