Let’s assume you have $50,000 in student loans. You’ve got another $50,000 – you could either pay off your student loans, or invest it in stocks and make 9% per year. We’ll assume you pay $450 a month in interest and principle to pay off your student loans in 15 years. I think that’s probably erring in favor of the loans as an option, because my guess is most people are paying less than that with a pretty low interest rate. That’s $5,400 a year you could save over the next 15 years. What would you end up with if you invested it instead?

If you save the $5,400 a year, you end up saving $81,000 in payments over the 15 years – a savings of $31,000 net in exchange for the $50,000 you paid. But if you’d invested it, you’d have $182,124 – a gain of $132,124. Pretty big difference.

What if you’d taken that $5,400 a year in savings and invested it each year? That’s the smarter thing to do, and closer to what your real choice likely is. But you’d still end up with $160,173 at the end of 15 years – about $20,000 less than what you’d have if you’d invested it. So even assuming pretty high student loan payments, you’re going to be better off having invested the money.

Is it ever a good idea to pick student loans first? There are a couple reasons outside this basic Excel-spreadsheet calculation to think about, however. For example, I paid off a smaller student loan I had because it was higher interest (7%) and I could eliminate a monthly payment pretty easily. The reduced stress on my monthly budget was worth it to me to get rid of that portion of my student loans. Another reason might be because you’re planning on borrowing a lot more money to buy a house and you don’t want to be carrying as much debt when you go into it. It can look bad on the credit report to be overextended. Then again, if you’ve got huge student loans, you’re probably not getting rid of enough of them to change a bank’s loan decision on your interest rate or whether to lend to you. And increasing your down payment by $5,000 is probably more likely to affect that decision that $5,000 less in student loans. In most situations, you’re better off saving that money and letting your student loans sit there at 3% interest until they’re naturally paid off.

Discuss this in the Free the Drones Forums.

Soft Drinks – I know lots of people who have 4 or 5 of these a day. Say it’s roughly 20 cents each – that’s $365 a year.

Smoking – This should be a no-brainer. If you quit, you’ll save thousands. According to this article, smoking a pack a day costs an average of $1,600 a year – the costs vary from state to state, but it’s obviously a big drain on your finances. Those costs add up – in fact, the single best thing someone older can do to save for retirement or pay down debts is to stop smoking. Check out these numbers:

A 40-year-old who quits smoking and puts the savings into a 401(k) earning 9% a year would have an extra $250,000 by age 70. 

So there’s a great motive for anyone thinking about kicking the habit – you can have the money to retire, and make sure you live to use it.

Alcohol – Say you go out once a week, spending $15 on those expensive beers or drinks the bar is selling. Over a year, that’s $800.

Eating out at restaurants – $20 once a week? That’s $1040 a year.

There are probably a lot of others you can think of, but you should be noticing a common theme: they’re all little examples of splurging for pleasure. Everybody’s got one – and honestly, it’s hard to live life without having something you buy or do every once in awhile to perk yourself up. But it’s also easy to substitute the expensive pleasures for cheaper ones. Can’t quit smoking? Buy a cheaper generic brand. Want that soft drink fix? Kick the Coke and get the 5 cent Grocery Store generic pretend Coke. Your friends want to go out all the time? Eat dinner beforehand and get an appetizer. My advice is to take a long, hard look at your spending and decide if it’s worth it – would you rather have the Cokes or the $250,000 you’d save up over time? It’s an easy choice to me.

Discuss this in the Free the Drones Saving Forums.

Read through the post for some other creative debt solutions – including using Prosper to get a lower-rate loan to pay off some credit card debt and transfering the balance of other debt onto a 12-month, no interest card.

Discuss this on the Free the Drones Credit Forums.

The answer sort of depends on what kind of debt you have, and it also depends on whether you’re talking about investing money in general or investing it in a 401(k) or other tax deductable plan.

The general rule is: if the interest rate on the debt is over 10%, pay it off first. If not, invest the money first. The reason for this is that if you put your money in an index fund that mirrors the stock market, you can expect to make 10-11% per year on average. If you pay off your debt, your return is the interest rate on the debt.

This general rule means that things like your mortgage, your student loans, and your car should not be paid off – you should invest instead. Your credit cards, however, will probably have higher interest rates than 10% – and you should pay those off before investing.

BUT – there’s an exception, of course. What if you are talking about money that you would be putting into a 401(k), IRA, or other retirement plan where the money is tax deductable? Then, it’s probably better to invest even in the case of high-interest credit cards. You get an instant return equal to your tax rate – and the 10-11% return per year as well. Plus, your employer might match the money, in which case you’d be insane not to contribute.

BUT – There’s an exception to the exception. Sometimes your financial situation is so precarious because of debt that you should focus on paying it down first anyway, even if it’s technically a lower return. If you are living on the edge each month, with very little extra, your short term goal should be to get rid of small debts whose payments you can eliminate. If debts have made your budget so tight that you can’t survive a minor emergency, you should put off the investing. Focus on those debts, get rid of enough that you have a few hundred a month wiggle room in your budget, and then go back to the 10% rule.

Finally, I’ll admit that there is psychological satisfaction in paying off debts. I’ve violated the rule myself, and continue to do so – I know I’m not making the best return, but I really like the idea of not having a car payment or cutting down on the number of student loan bills I get every month. I’d probably pay off a mortgage early myself, just on the principle that when I retire, I want as few expenses as possible.

But there’s always an element of do as I say, not as I do – the smartest advice is to invest. And in my situation, I’ve got plenty going into the investments as well. So keep all these things in mind when making your decision.

Have a financial problem? Ask about it on the Free the Drones Financial Forums.

Ulysses wanted to hear the song of the Sirens, but obviously didn’t want to die. His solution? He had his crew tie him to his mast so he couldn’t move, while they stuck wax in their ears. He got to hear the song, but wasn’t able to kill himself.

I thought about that when reading this post about frozen credit cards on the Birds and Bills blog. The idea one shopoholic had was to freeze her credit cards in ice, so that to use them she had to wait several hours for them to thaw out. This would force her to think about the purchase beforehand rather than acting on impulse.

That’s a little extreme, but the idea of precommitting yourself if you’ve got a spending problem is a good one. Some ideas that are less damaging to your credit cards:

1) Have a trusted friend hold onto the cards for you. Instruct them not to give it to you until 3 hours after you ask for them, and have them warn you when you ask and when they give it to you, “You’ll regret doing this in the long run.”

2) Put them in a safe deposit box if you’ve got one – it will make it a big hassle to actually use the credit cards.

3) If you want to be really extreme, and only use them in absolute emergencies, bury the thing in manure or something else that disgusts you. It won’t break it (ice can make the card brittle), but you won’t be touching it unless you’ve got a serious problem.

Discuss this on the Free the Drones Forums 

“Maxed Out examines an industry that thrives on making people fail, then pursues them relentlessly to death’s door. The film features a shocking interview with Bob and Chris—two idealistic entrepreneurs from Minneapolis whose “People First Recoveries” is buying bad debt all over the country in the hopes of huge profits. They’re going to make “People First” a big success by being shockingly duplicitous. To get psyched up, Chris and Bob imagine themselves as “debt pirates”, wrestlers and professional football players. The personal information at their disposal and the ways in which they are allowed to use it—calling people’s neighbors and relatives to humiliate them into paying, for example—are nothing short of terrifying for us, fun for them.”

It also highlights the attempts by credit card companies to target college students, a target easily seduced by access to more stuff to spruce up the dorm room.

While I think it’s important to shine some light on negative practices in the debt collection industry, what I don’t like is the complete effort to avoid discussing personal responsibility among those who have borrowed themselves into debt. Credit card companies do indeed try to nickel and dime you every way possible – but in the end, no one else forces you to use them. And by the same token, no one else is going to force you to stop. You have to take the initiative to do that yourself, and getting angry or moping about how credit card companies exploit people isn’t going to bring you one bit closer to freeing yourself from credit card debt. By all means watch it and be aware that sharks are swimming in the sea – but the best way to avoid them is to get out of the water.

Discuss this on the Free The Drones Forums here.

1) What kind of debt do I have?

The first question matters because some debts might be better off left alone than paid off. Why would you want to be in debt? Well, it’s not so much that you WANT the debt – just that you’re better off having it and doing other things with your money. The two most common “good” kinds of debt are student loans and a home mortgage.

Student loans are usually locked in at very low rates, especially if you consolidated them. These low rates generally mean that you’re better off investing your money than paying down the loans. If you can earn 8% per year on the money in a generic, Standard and Poors Index Fund of stocks, why would you spend it paying off debt when you only “earn” 3-4% of interest you no longer have to pay?

Mortgages are another example of debt that is often a necessary evil. It’s nearly always better to own a house than to rent – and for most people, borrowing is the only way to do it. You should pay your mortgage down until you hit the threshold where you no longer have to carry insurance – usually this kicks in when you have 20% equity in the home. After that, there are probably better investments than repaying your mortgage debt, both because you can deduct interest on your taxes on your residence and because money you put into stocks will “compound” – you’ll get gains on the gains, whereas you get any increase in the value of your house regardless of whether you pay down the debt.

What about the bad kinds of debt? Anything high interest. Auto loans are often necessary, but you’re much better off if you can pay them down or eliminate them entirely, because they suck away money that could be used for investments – and in many cases at fairly high interest rates. Credit cards are a no-no, and ideally you shouldn’t owe a cent. But there are even worse forms, such as pay day loans or pawn shop loans. Avoid these unless you’re in a dire emergency – and even then, they’re usually not a good idea. If you owe any of these ultra-high interest loans, you should always consider yourself in too much debt and begin focusing your budget around paying them off.

2) What percentage of my income am I paying each month to keep up on my debts?

This calculation is crucial. There is a calculator here that will help you perform it in more detail. A good rule of thumb is that with mortgages included, your debt should not be higher than 40% of your gross income. This means you take the salary you make before taxes and any sort of deductions – let’s say you make $2,000 a month pre-tax. That means you shouldn’t be paying more than 40% of this, or $800 a month, on all your debts combined. This is regardless of whether your debts are considered “good” or “bad” kinds of credit to have - even too much of a good thing can be bad. If you don’t have enough money each month for basic living expenses, you’ll be tempted to use the credit cards. You also won’t be able to sock away a decent amount for your savings – a crucial part of making sure you can retire.

This leaves us with two basic rules for when you NEED to start reducing your debt levels:

1) If you owe anything on your credit cards, on a high interest car loan, or on any other high-interest debt (any rates above 7% per year).

2) If you are paying out more than 40% of your gross income each month in interest payments.  

Discuss this in the Free The Drones Forums here.