Invest or pay off debt?

The one financial question everyone wants to know the answer to is: am I better off investing my money or paying down my debts? The answer is not as difficult as one might suppose. Although, it can get murky, depending on how comfortable you are with the debt.

The 6% rule

To make this analysis as simple as possible, be sure to follow this rule: If your debt costs you (ie, the interest rate you pay is) 6% or more, you should always pay off the debt before you invest. A 6% return is a conservative number to expect from the stock market. Many experts will say that the market has historically returned 8-10% per year. While I don’t disagree with those experts, no one can predict the future. We do not know what the market will do in the future. As a result, I will be conservative and use 6% as the average market return per year.

Now what do you do with any debt you have that is less than 6%? This answer can also be easy. You need to ask yourself this: how comfortable are you with your debt? This question doesn’t simply ask if you can afford your monthly debt payment, although that is part of the question. Most of the question is wondering if you are capable of handling debt emotionally. Is the burden of debt keeping you awake at night? If he answered yes, then he is not comfortable with his debt and must pay it. If you worry at random times about your debt, again, you are not comfortable with your debt and you need to pay it off. If none of these scenarios describe you, you may want to take it a step further and really take a look at whether you’re better off investing or paying down your debt.

The decisive formula

To determine which one is right for you, you’ll need to do a little math. But don’t worry, the math isn’t hard. The first step is to take your debt (in this case, you’ll calculate each debt you have separately) and compare it to your after-tax investment statement. In this first example, we’ll assume you have $5,000 in credit card debt at 4%. Since you can’t write off the interest you pay on your taxes, we don’t need to calculate the after-tax cost of debt. For all debts you can’t pay off the interest on, the rate you pay is your after-tax cost. In this case, 4%. Next, we’ll assume you’re in the 25% tax bracket. You can determine your tax bracket by looking at last year’s tax return. Take the 6% investment return assumed above and multiply it by 1 minus 25%. The formula looks like this: .06 (1-.25). The answer is 4.5%. In English, this means that, after tax, you earned a 4.5% return on your investments. Compare that to the 4% you pay in credit card interest. Mathematically, you are better off investing your money as you get a higher return.

But, the higher return you get is only a percentage. It’s worth it? This is where we get back to what matters most to you? Technically speaking, in this example, the difference is not material, meaning it is too small to matter. Whichever option you choose, it is the right choice for you. After all, personal finance is just that, personal. You decide what is best for you and your situation.

Now let’s say you have a 6.50% mortgage. Since the interest you pay on this debt is tax deductible, we need to complete the calculation for both the after-tax cost of the debt and the after-tax cost of the investments. We will assume the same facts as above with respect to the 25% tax bracket. Here, you’ll take the 6.50% interest on your mortgage and multiply it by 1 minus your tax bracket. The formula is .065(1-.25). The answer is 4.88%. Effectively, the after-tax cost of your mortgage is 4.88%. When you invest, you will earn 4.5% (as seen in the after-tax investment example above). In this case, you must pay your mortgage instead of investing.

If you go through this process and the answer you get is to invest and after a few months you have second thoughts, then by all means stop investing and pay off your debt. That restlessness you feel is your instinct telling you that this is not right. Listen to your gut.

If you have multiple sources of debt, simply do this calculation for each one that has an interest rate of less than 6%. You can then see which debts you need to pay off and which ones you need to pay the minimum and invest instead.

conclusion

In short, if part of your debt exceeds 6%, there is no math involved. You better pay off your debt. At the opposite extreme, any debt that is 2% or less, you should invest your money. You can easily earn more than 2%, even on bonus funds. It would be better to invest instead of paying off debt. Of course, this also goes back to the earlier point that personal finance is personal. If you still prefer to pay off the 2% debt, go for it.

For any debt between 2-6%, you need to do the quick math above to arrive at your bottom line.