It doesn’t really matter where you heard about it, whether in a conversation with a colleague or from one of the many financial planners you’ll find on CNBC, but the question is the same; is it better to pay off your debts first or to start investing first?
Although it’s a question that has nagged at investors for decades, it’s actually one that can be answered by using a little bit of basic math.
It doesn’t matter whether it’s student loans, credit cards, an automobile loan or the mortgage on your home, there’s no doubt some debt that you owe and, if you’re a relatively intelligent consumer, you’ll also want to pay that debt as quickly as possible.
It’s also quite understandable however that you would want to start putting money aside for retirement, to purchase a new home or for some other important financial goal that you have.
The problem is that, with only so much cash available, consumers have to make a choice between one or the other.
So again, what should you do first, pay off your debt or invest that money? The answer actually depends on two different variables. The first is the rate of interest that you’re paying on your debts after taxes, and the second is the rate of return that you can expect, after taxes, to earn on any investments that you make.
The first thing you actually need to do before you answer that question however is to understand that there are, in fact, two very different kinds of debt. The first is high interest debt on things like department store credit cards, while the second, less nasty debt is the type that you would have on, say, a home mortgage.
With these two types of debt in mind, the age old question to reducing debt versus investing that money can be solved by answering this one simple question; can you earn a higher after-tax return on the investments that you plan to make than the expense of the after-tax interest rates on your debt?
If you answer yes, then you should definitely invest. If you answer no, you definitely should pay off your debt balance first.
Here are two good examples of weighing debt reduction vs investing
Let’s say that you have a 30 year, $150,000 mortgage that carries a 6% interest rate and that you are in the 25% tax bracket. In this case, the actual percentage rate that you will pay after your itemized mortgage interest deduction would be 4.02%. Thus, if any investments that you will make will earn more than 4.02%, and if you invest for the long term that’s a distinct possibility, you should definitely begin investing now.
Now let’s say that you have a credit card balance of $10,000 and an annual percentage rate of 22%. Remember that interest on credit cards is not tax-deductible, meaning that the only way that an investment would be a better choice would be if it returned 22% after taxes. Even looking at the long-term return on equity, which has historically been somewhere between 11 and 12%, it’s highly unlikely that any investment would be able to return enough money to make it worthwhile to invest, which obviously means that paying that credit card debt first is your best choice.
So what’s the bottom line?
Simply put, doing what’s best for your bottom line is the bottom line. You might be extremely eager to invest but frankly, Paying off that high interest debt will actually save you more money than any investment might earn you. Once it’s paid, definitely start putting your money into excellent long-term investments.
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