This question comes up to us a lot as people come to us for business advice. Unfortunately, most people today have more debt than they would like. We understand … when we graduated college, we not only had a combined ~$70,000 in student loan debt, but we also had several thousand more in credit card debt.
So we put together a massive guide on not only getting out of debt, but how to leave your job by building a business. We call it “Find Your Freedom“.
The reason a lot of people look to become entrepreneurs is not only for the perceived time freedom but also for the financial freedom. Starting a business or making an investment can be a great way to generate additional income, but in many cases, you may be better off to wait and pay off your debt first. Ask yourself the questions below to see what make sense for your situation.
What Type of Debt Do You Have?
All debt is not created equal. Tom read Rich Dad Poor Dad a few years ago and it changed how we look at assets vs. liabilities. We no longer look at our house as an asset (even though the bank does). We now define an asset as something that provides us money every month, but our house costs us money each month. So even though we do have a mortgage and it is a liability, we are OK with that. The same goes for our student loans. Because the rates are low and interest is tax deductible, we are not in a huge rush to pay these off. These also do not hurt our credit score, and in a lot of cases can help it by showing long-term debt that is paid on consistently.
Credit card debt, on the other hand, is a different story. The rates are typically higher and if you are using over 50% of your available credit, it can hurt your credit score. So ask yourself the following questions when you are trying to make the decision.
What Is Your Debt Costing You?
From a mathematical perspective, the answer is pretty straightforward. Just ask yourself this question… can your business or investment make you more than what you are paying in interest on your debt?
For example, if you have student loan debt that you are paying a low rate on (ex. our loans are locked in at 4.25%), then if you can invest or create a business that returns more than 4.25%, it makes sense to invest rather than to pay down the debt. We will probably always choose to invest before paying off these student loans debts because the rates are so low and we can make much higher returns with our businesses.
But on the other hand, if your debt is with credit cards and you have a higher rate like 15% or 20+%, you are more than likely going to be better off to pay the down debt first. If you invest or start a business and make a 10% return, but are paying 15% on your debt, you are losing 5%.
What Business/Investing Opportunities Do You Have?
Adding on to the previous question, what opportunities are out there and how much can you make from them? If you can make a higher return than the interest rate on your debt, then you might be better off investing first and using your returns to pay down the debt.
As an example, our first real estate investment was a duplex. The total cost of the investment was $8,000 (20% down payment + closing costs). We partnered with another investor, so we invested $4,000. Total monthly rent was $1,225 for this property. Deducting 50% of rents for ongoing maintenance and expenses, that leaves us with $612. After our $288 mortgage payment, we are left with ~$325 in monthly cash flow. This equates to $3,900 cash flow a year, or $1,950 for each us and our business partner. Looking at our initial investment of $4,000, that is a cash on cash return of 48%!
As you can see, if you have the ability to start a business or make an investment that does provide you a great return, that may drive to you focus on that before paying down your debt.
Should You Pay Off Debt & Are There Other Factors?
Some people (like my loving husband) just have the itch to start investing or start a business. When we were looking for our first house, Tom was adamant that we buy a duplex. As Tom described, he failed to convince me to buy a duplex when we bought our first house, but we purchased our first duplex several months later. In some cases, it may make sense to go against the numbers if it will satisfy an emotional need. These pros and cons have to be weighed, but in most cases, I would recommend listening to the numbers. If the numbers say to pay off debt, then do that and start your business afterward. You will have more cash and not be throwing money away on interest. If the numbers say to start your business, then, by all means, get started!
Full Disclosure: We did not follow our own advice here. In Tom’s recent blog, What $15,000 in Real Estate Investing Training Looks Like, you get to hear about how Tom not only did not decrease our debt before starting our real estate business, he actually went out and added $7,500 to our credit card! Talk about how to not make a happy spouse!
Are you looking for support and guidance as you start your business? Be sure to check out our Lifestyle Builders Mentorship. It is very affordable and one of the best investments that you can make for yourself.