How to Decide Whether to Invest or Pay off Debt
from wikiHow - The How to Manual That You Can EditWhether it's a mortgage, personal loans, credit cards or all of the above, more and more people are drowning under the burden of their debt, and for those with enough income to keep their heads above water, the only logical choice may seem to be paying off their debts as quickly as possible. But wait -- is that really the best financial game plan? While it certainly feels good to be debt free, in some extremely rare situations you may be better off simply maintaining your debts (i.e. paying the minimum payments on your loan) and investing your spare cash. Can't decide whether to invest your extra money or use it to pay off your loans? Read on for some tips to help you make the choice.
Steps
- Start a budget -- a spending plan. Before you can even consider investing, you've got to make sure that you actually have extra money. Reserve enough income to keep all your debts current; getting behind on your debt payments can damage your credit and cause you to incur fees that will quickly overwhelm the return on any investment. Pay at least your minimum payments on all your debts, on time, every time.
- Build a rainy day fund before investing. Things may be looking up now, but what if you lose your job next month or you have a medical emergency? Before you invest or make larger than necessary payments on your loans, save up some money for an emergency fund. Many experts recommend that you save enough to cover at least three months of your bare-bones expenses. This number may vary, however, depending on your situation and your personal preferences. This money should be in a safe, accessible account, such as a money market fund, not a mutual fund (no guaranteed return over short periods of time) or a CD (not accessible).
- Think of debt payments as an investment. When you make a $100 payment on a loan with a 13% interest rate, your annual return is 13%, or $13. Why? Because you avoid having to pay that extra $13 in the future, which leaves you $13 more than you would have otherwise had.
- Prioritize your debts. Some financial experts suggest putting your debts in order from those that charge the highest interest rates (often credit cards) to those that charge the lowest (typically mortgage payments). Others, like Dave Ramsey (in his book Financial Peace Revisited), suggest listing them from smallest to largest, paying off the smallest debts first while making minimum payments on the rest. Then, as the smallest debt is paid off, the amount that was being paid on it is rolled up onto the next highest debt, added to that debt's minimum payment. This is called the "Debt Snowball," and can give a tremendous sense of accomplishment and encouragement to anyone with a large number of debts to pay off.
- Compare the annual return on investments to the interest rates on your debt. When examining an investment opportunity, compare its rate of return to the interest rates on your debts. Suppose you're trying to decide between paying off your mortgage early by paying an extra $100 per month, or investing that $100 each month. If your auto loan's interest rate is 6%, you can get a better return by investing that $100 in any investment that yields more than 6%. If you're considering a bond that pays 5%, however, you're better off paying the extra $100 on the loan. Also ask yourself if you would borrow new money at the debt rate to invest at the investment rate. If you wouldn't borrow new money, you should pay off the debt before investing.
- Consider the tax implications. It's not enough to simply look at the interest rate you'll receive on an investment or pay on a debt. You also need to consider whether the interest on your investment is taxable and whether the interest on your debt is tax-deductible. Taxes can complicate things a good deal, so unless you are confident in your ability to navigate the maze of tax laws and do your own calculations, you may want to get expert help from a financial advisor. Consider the following U.S.-based examples.
- Mortgage interest payments are usually tax deductible, so the effective interest rate you pay on your mortgage may be substantially lower than the stated rate. (Note: You only benefit from the tax-deductible nature of mortgage interest if you itemize your deductions on your tax return. Taking the standard deduction nulls any perceived "benefit" of mortgage interest.)
- Ordinary investments are generally subject to income taxes, which can dramatically reduce the return.
- Tax-deferred investments, however, such as 401(k) plans and traditional IRAs, lower your taxable income, and thus the effective return may be higher than the stated rate.
- Mortgage interest payments are usually tax deductible, so the effective interest rate you pay on your mortgage may be substantially lower than the stated rate. (Note: You only benefit from the tax-deductible nature of mortgage interest if you itemize your deductions on your tax return. Taking the standard deduction nulls any perceived "benefit" of mortgage interest.)
- Pay off debts that have higher interest rates than the return you can get on investments. There's a good chance you can find a relatively safe investment that would pay more than the interest on a low-rate mortgage. It's quite a bit harder, however, to find an investment that offers a better return than paying off your 21% credit card balance without an amazing degree of risk, (unless someone's paying you to invest -- see the tip below). Thus, with your prioritized list of debts in front of you, use your extra money to pay off those with the highest interest rate first. Another strategy is to pay off any small balances first (even if they have low interest rates) which frees up cash flow for investing or for paying off your other debts.
- Invest only when you can reasonably expect returns that significantly exceed the interest on your debts. Eventually you'll have paid off your high-interest obligations and likely be able to find acceptably safe investments that will provide a better return on your money than paying extra on your lower-rate debts. At this point, it generally makes sense to invest, rather than pay anything over the minimum payments on your loans.
- Consider the risk. Unlike the guaranteed "return" you get by paying off debts, investments carry risk. Low risk investments, such as interest-bearing savings accounts, CDs, and guaranteed government bonds, are pretty safe, but they're unlikely to exceed the returns you can get by paying off even low-interest debts. A wide variety of other investments, including stocks and mutual funds, may provide returns that beat even credit card interest rates, but those returns are not certain, and you could even lose your principal. In general, the higher the advertised rate of return, the higher the risk. You have to consider your own risk tolerance when considering an investment.
- Think about your future financial obligations. When you apply for a mortgage or other forms of credit, your interest rate (the cost of the money you want to borrow) will depend largely on your credit rating. One of the main factors that determines your credit rating is the amount of credit you're using relative to that available to you. Thus in some cases, it may benefit you to pay down debt—even if it looks like your money can earn a better return in a relatively safe investment—because your improved credit profile will save you money on a mortgage.
- Consider the risk. Unlike the guaranteed "return" you get by paying off debts, investments carry risk. Low risk investments, such as interest-bearing savings accounts, CDs, and guaranteed government bonds, are pretty safe, but they're unlikely to exceed the returns you can get by paying off even low-interest debts. A wide variety of other investments, including stocks and mutual funds, may provide returns that beat even credit card interest rates, but those returns are not certain, and you could even lose your principal. In general, the higher the advertised rate of return, the higher the risk. You have to consider your own risk tolerance when considering an investment.
Tips
- If you are married, be sure you and your spouse agree about the course of action you propose. When in doubt, pay debt first, and work out a compromise. Perhaps the more cautious partner will favor beginning to invest when your debt is lowered beyond a certain point.
- If someone's paying you to invest, you may need to change your calculations. Who would pay you to invest? Most likely your employer. If you have a 401(k) plan, for example, your employer may match all or part of your contributions. In this case, your savings rate immediately goes up 50-100%. This return beats almost any debt's interest rate, so it's often a good idea to contribute the maximum amount your employer will match before you pay extra on your debts. Keep in mind, however, that you still risk losing money in the investment plan. More importantly, be sure to consider the vesting requirements for your employer's contributions. If you're not likely to stick around long enough to be fully vested you won't receive the matching contribution.
- Investing and prepaying your debts is not an either-or proposition. If you have paid off your high-interest debt, and would like to start investing while still paying extra on your student loan or mortgage, then go for it! Split your monthly surplus (or whatever you were paying on that last debt you paid off) in half, and invest one half while using the other half to prepay your loan.
- The same considerations can help you choose between a shorter term (15 year) mortgage and a longer term (30 year) mortgage. Since you usually get a lower interest rate on the shorter term, your savings (the difference between the total payments made on the 30 year and the 15 year) can be considered the return on your investment in the shorter term mortgage. This return, however, is higher the shorter you stay in the house. If you sell the house in 2 or 3 years, you will get a higher annual return than if you sell it in 12 years. Some people take out a 30-year mortgage even when they can afford the payments on a 15-year mortgage, and they often do so because they intend to invest the difference in the monthly payments. This only makes sense, however, if the annual return on the investment exceeds the annual return you get by choosing the shorter mortgage AND you actually invest the money. If you don't have the discipline (and most people don't) to invest religiously, the shorter loan term should force you into saving while accumulating equity faster with a higher payment and quicker payoff.
- Being debt free allows you to invest more aggressively and be more generous with charitable giving.
- There are a variety of calculators available on the internet that can help you choose between investing or paying off debt or between a short mortgage or a long one.
- Find others who are enthusiastic about reducing the debts in their life, and meet with them on a regular basis. Develop accountability partners who can help you make decisions about major purchases and walk with you through life as you climb out of debt.
Warnings
- Investments carry risk, and choosing to use your money to invest rather than pay off debts more quickly is inherently risky. The amount of risk depends on the investment, of course, so you need to consider each investment opportunity carefully. Remember also, however, that neglecting your retirement savings (even if doing so to pay off debts early) is also risky.
- Most of those internet calculators assume your investments will go well, and don't take into account the risk involved. If the investment doesn't go well, you may find yourself miserably paying off the debts while having little or nothing to show for your "savings".
- This article is intended as a general guide only and is not intended to replace professional financial or legal advice.
- Never borrow money with the sole purpose of investing it. Most investments (if not all) do not have a "guaranteed" return rate. All loans will require you to pay interest on them. It is too easy to be caught between a low-paying investment and a higher interest loans.
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