- Personal Finance»
- Debt & Bankruptcy
How to Invest Your Way Out of Debt to Make Interest Work for You
Get in a Little Over Your Head With Credit Cards? Don't Stop Investing!
If you are anything like most Americans, once in a while you have to pull out the plastic. Sometimes, you even pull out your plastic when you probably shouldn't to buy things that you probably shouldn't. It happens to the best of us. Unfortunately, the banks seem determined to profit on the backs of the American consumers through very high interest rates and aggressive lending practices.
What can you do to preserve your savings when you face the prospect of unplanned, unexpected debt? Normally, you would be advised to aggressively throw money into the black hole of credit card debt until it is paid off. You may climb out of debt, but your capital is lost chasing down your monthly interest. For large credit card debt, over 5000 dollars, with high interest rates, the strategy I'm about to explain is not ideal. In case of severe debt, seek professional help through government sanctioned debt-counseling services and/or the aid of a qualified financial adviser you trust.
For small to medium-level debt, a different approach protects your savings and investments while aggressively paying down the interest rate of your debt. For lower interest credit card debt, student loans, and even mortgages, you can use a portion of your savings as a temporary source of dividend yields to supplement your debt repayment.
This Strategy Isn't For Everyone, or For All Debt!
If you are having real trouble with credit card debt, you need to contact credit counselling services and do something to deal with your problem. Most states have a credit counselling service that can help you put a strategy in place to deal with your debt. Investing your way out of debt is ideal for moderate and low debt, not for larger debts. I've heard advisers suggest this strategy for mortgages, and low-interest debt. The same strategy will work with some credit card debt. If you can afford to wipe away your debt with one check, that's almost always ideal. Once debt is gone it is not building up any more interest off. Dividends are not guaranteed over the life of your mortgage. It is wise to carefully consider this strategy to see if it is right for you before making any investments.
This strategy uses a part of your savings as a temporary source of dividends to supplement monthly, budgeted payments.
Let's See How This Works
An investment in a relatively stable, dividend-paying stock like the power grid managers at National Grid (NYSE: NGG) will pay out a dividend every year of about 5.9%, at the time of this writing. At an investment of just under 50 dollars a share as of this writing, let's estimate you buy in for two-thousand dollars out of your savings to start your dividend debt reduction "battery". This one-time purchase will lead to a dividend payout of about 76 dollars a year, with the possibility of an increase every payout. The relatively stable, mature stock should maintain value even as you use your investment to supplement your debt payments. (Edit to add: Commenter is correct, and this British company pays out twice a year, generally, and it threw my math off. It's still a good idea!)
Now, after your initial buy-in, you can pay down your debt at the minimum amount you can afford in your monthly budget, and supplement your debt repayment with 76 dollars every year from your extra "debt-reduction battery". This "battery" will preserve your principle savings in relatively stable, dividend-paying stock while going to work to reduce your debt. You don't have to sacrifice your savings account on the alter of debt. This dividend payout, though relatively stable compared to other possibilities does not even begin to touch the high returns possible through investments in High Yield Real Estate Investment Trusts. REIT stocks must pay out 90% of their profits to investors to maintain their tax advantages. These are popular stocks for diversifying a portfolio into strong dividend plays, but, like all investments that seem too good to be true, they are a riskier investment.
In the current climate, Real-Estate Investment Trusts are a relatively risky investment, because the Fed can raise interest rates to destroy the earnings of most of these stocks, but for an investor willing to take on some risk, they offer the opportunity of astonishing yields as high as 20% in some cases!
REITs Can Be Risky, But Can Also Produce Strong Yields!
Let's take the case above, with National Grid, and compare what happens when that same 2000 dollar investment is dropped into American Capital Agency Corps (NYSE: AGNC). At $30.33 a share at the time of this writing, the initial investment of 2000 dollars leads to about shares of American Capital Agency Corps stock. With very high yields even for an REIT at %18.47, the dividend payout every quarter will begin at about 91 dollars. The higher yields are not guaranteed, especially in the REIT sector, but as long as the Federal Reserve Bank keeps interest rates low, this stock pick will continue to pay out a strong yield as the company profits from the spread between low interest federal debt and higher-interest mortgage rates.
American Capital Agency Corps is a particularly high yielding REIT, at the moment, even among its peers, but that's why I selected it as an example here. Be sure to invest in your REIT carefully. Just chasing high yields does not lead to a successful investment. If the dividends can't be maintained, or the stock loses value, your risky, exciting investment will suddenly seem a lot less shiny.
This is a riskier investment move, ideal for amounts of debt below 5000 dollars. The time horizon on this strategy should probably not exceed two years. REIT stock is more volatile than a stable, mature business like a power grid company. To qualify as an REIT, companies are legally required to pay out 90% of their profit as dividends to shareholders. Without the ability to make strong reinvestments, the only way the company can grow is by selling more shares of stock, diluting the value of the stock you own!
Still, supplementing your monthly budgeted payments into your credit card debt can easily be supplemented by high-yield dividend stocks. If you have some savings you wish to preserve while also being aggressive about your debts, this strategy may work for you.
REITs can be a riskier play than a mature business, but if you are comfortable with that risk and believe you will be done paying down your debt before the Federal Reserve Bank raises interest rates, this might be the way for you to supplement your debt repayment with dividend yields.
A Word of Warning about Diversifying
I used the example of 2000 dollars above, but it was only an example. It is a good idea to diversify your investments, always, and a combination strategy that involves two or three high yield stocks is probably a better idea if you are dealing with investment amounts exceeding 2000 dollars. For instance, if you have 10,000 dollars saved up, and you want to use this as your temporary debt-reduction battery, I strongly advise diversifying your investments and speaking with an investment professional. All investments come with risks, and you should be careful with your strategy.
When I chose this strategy to clear some old student loan debt I had approximately 5000 dollars remaining which had an interest rate of 4.5 percent. I took a small piece of our family emergency fund of approximately three thousand dollars and divided it into three investments. I chose a Vanguard STAR fund, at an initial investment, to preserve my capital in a diversified investment while receiving dividends. Then, I invested in Annaly Capital Management, at the time a popular and growing REIT. Finally, I invested in Johnson & Johnson. I paid the monthly amount we could afford to my student loan with checks, then I relied on the windfall of dividends to pay out even more on top of my monthly payments from the invested savings.
It was working! I thought I was very clever until the Great Recession struck! I have managed to pay off that debt, but not without some surprises when my investment in Annaly Capital Management, in particular, experienced some extreme turmoil!
We're attempting this strategy again in my household, for some credit card debt after a car repair. We're investing in two REIT stocks, and one strong dividend paying energy company. (None of them mentioned in this article!) We believe we won't see another Great Recession, and have even managed to earn back what we lost in our savings through the dividends from the investments!
This is a strategy that worked for me, once, but it isn't for everyone, and it isn't for all kinds of debt. Talk to your financial adviser and see if this strategy might work for you.