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Should You Invest or Pay Down Debt?

by J. Money on Monday, August 9, 2010

debt sign

(Guest post by Laura Adams)

People often ask me about whether they should focus on investing money for the future or on paying down their debt. If you’re fortunate enough to have some excess cash at the end of the month, maybe you’ve also wondered about the best way to use it. Just about everyone has some debt—like a student loan, car loan, or a lingering credit card balance—that they really want to pay down. But you also want to save or invest your spare cash for your retirement. That may seem like a tough decision, but the information in this post will give you a clear direction for what to do.

Follow These Financial Priorities

Whenever you have any extra money in your pocket, make sure to take care of these financial priorities, in this order, before you do anything else:

  1. Pay down any delinquent debts that could threaten your well-being or credit score, such as an overdue tax bill or legal judgment.
  2. Accumulate a financial safety net. If you don’t have at least three to six month’s worth of your living expenses saved up in an accessible emergency fund, that’s the next place your extra money should go.
  3. Pay down high-interest debt. If you have credit cards, lines of credit, or auto loans, with double-digit interest rates, attack those financial burdens next.

Determine the Highest Return on Your Money

If you’ve accomplished the above and still have excess money left over each month, you’re in a great position. Maybe you have an extra $100 and are struggling with whether to invest it in your Roth IRA or to use it to pay down your mortgage, for example. The answer to the dilemma is simple: Determine which option is more profitable for you. To do that, you have to figure out your after-tax return for each choice.

Get a Guaranteed Return

When you pay off a debt early, you’re actually earning a guaranteed interest rate that you’d otherwise have to pay. So if you pay off a credit card that charges you 18% interest, you’re making an 18% return. But in the case of some debts that come with a tax deduction, like mortgages, home equity lines of credit (HELOCs), and student loans, you can save money on taxes, which lowers the effective interest rate that you really pay. So those types of debt are typically the ones that you should pay off last because they cost you the least. The amount of tax savings you get on a tax deductible loan depends on your income tax rate and any maximum deduction limit that may apply.

Example of a Mortgage’s After-Tax Return

Here’s a quick example: Let’s say you have an interest-only mortgage of $200,000 with a 6% annual interest rate. That means you pay $12,000 per year in interest ($200,000 x 0.06) which is fully tax deductible. If your effective tax rate is 25%, you would save $3,000 a year in taxes. When you take that fantastic tax savings into account, your mortgage only costs you 4.5% ($9,000 / $200,000) in interest.

Example of an Investment’s After-Tax Return

Now, let’s switch gears and talk about your other option that I mentioned in my example—investing an extra $100 it in your Roth IRA. Let’s say you’re considering a mutual fund that has an average annual return of 8%, including fund fees. With a Roth you have to pay taxes upfront, but then get to make qualified withdrawals during retirement completely tax-free. If your effective tax rate is 25%, then your after-tax return on the investment nets down to 6% (0.08 x 0.75).

Compare Your Financial Options

Since a 6% after-tax return on a mutual fund investment would be higher than your after-tax savings of 4.5% on your mortgage, opting to invest your $100 spare money each month is a better use for it. The investment yields 6% whereas paying down the mortgage would only yield you 4.5%. However, taking the investment route involves some level of risk and isn’t a guaranteed return.

Therefore the best choice for you depends on your tolerance for risk and your long-term financial goals. If you still feel conflicted about the issue, one solution is to do both. You could send $50 to pay down your mortgage each month and $50 to build wealth in the higher-yielding mutual fund investment.

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Laura Adams is the author of “Money Girl’s 10 Steps to a Debt Free Life,” and she also hosts the Money Girl weekly podcast over at Quick and Dirty Tips. For more money tips, advice, news, and resources, you can find her on Facebook as well as Twitter.

(Photo by Daquella manera)


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{ 8 comments… read them below or add one }

1 SAFTM August 9, 2010 at 10:07 am

I agree that the best choice for you depends on your tolerance for risk and your long-term financial goals. But if debt really is a “problem” for you, I would think changing your behavior is “of value” too. So if I had a problem with debt – especially credit card debt – I would focus on paying down debt at first. I wouldn’t worry about the math.

And even with tax-deductible debt, once you factor in risk and tax treatment of gains, you may find that – for the short period of time it will take to pay down your debt if you’re really focused – the potential gain is not worth the risk. Finally, there is some value to being debt free. It simplifies things.

But I don’t mind the “do both” suggestion. In the end it’s “personal” finance. So do what works for you. But I doubt you could “save” or “invest” your way out of debt if you have debt problems (maxed out HELOC, credit cards, car loans, etc.). I think that’ a behavior problem and the “interest rates” are not the issue. I would stop trying to do the math and focus on changing my thinking.

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2 Debt Vigilante August 9, 2010 at 12:48 pm

To me it would all depend on the how much you owed as well as the type of debt. All of my current debt are student loans – for me, the best return on investment is to pay those off as soon as possible. Every situation is different and personality of the person will come into play as well.

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3 J. Money August 9, 2010 at 3:01 pm

Yeah, personality def. comes into play. Although I’ll admit I happen to saver from “don’t mind having debt as long as I’m saving lots of money!” to “I hate debt! Want zero of it even if that means zero emergency fund!” haha… I think going with what feels right for you at any given point in time is the way to go. You might change your mind here and there, but as long as it makes you COMFORTABLE you’re a-okay :)

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4 ajc @ 7million7years August 9, 2010 at 8:28 pm

“The answer to the dilemma is simple: Determine which option is more profitable for you. To do that, you have to figure out your after-tax return for each choice.”

Agree completely; people have the erroneous idea that there’s a concept such as Good Debt and Bad Debt. That’s all well and good when deciding whether or not to take on the debt.

But, once you’re in debt, there’s only Cheap Debt and Expensive Debt: cheap debt helps you fund other investments (kind of a proxy investment loan) … and, expensive debt is, well, expensive and should be paid off asap.

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5 StackingCash August 10, 2010 at 3:17 am

Here we go again. Average rate of return of 8%. I love how those in the finance industry pick numbers like that and make you think it’s conservative yet never tell you that that rate of return can be 0% depending on what you invest in. You better pray that the mutual fund you pick is a good one because there are hundreds of bad ones out there. Picking mutual funds these days is as bad as picking stocks IMHO.

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6 Laura Adams August 10, 2010 at 7:30 am

@StackingCash As I mention in the article, investing is risky and provides no guaranteed return. However, historical returns in the stock market exceed 8% for long-term investors. If mutual funds make you uncomfortable, index funds may be a better choice.

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7 Brad Chaffee August 10, 2010 at 2:45 pm

I believe in paying off any and all debt before venturing into investing. If someone struggles with debt, how could they possibly believe they would be ready to invest? Then of course there are the ones that believe in leveraging debt to invest but I believe only a select few can benefit from that rabbit hole.

Pay off debt!

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8 J. Money August 10, 2010 at 4:54 pm

Haha… YOU? Hate debt? no way!

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