Should I Invest Or Pay Down Debt?
This is one of the questions I get most. As people enter the phase of their lives when there is leftover cash flow each month, they are tugged in both directions. On one end, there is a car payment, mortgage, or student loan that could be paid down. In the other corner there are talk show hosts and friends telling stories of people getting rich by investing their money. What do you do?
It’s All About Opportunity Costs
The quick answer to whether you should pay down debt or invest first comes down to a simple question, “which action will make you wealthier in the long run?” If you pay down debt, there is an opportunity cost of potentially missing out on making money investing. If you invest your money, your opportunity cost is the interest you would have to pay on debt. Therefore, if your cost of debt is 3% and you can earn 7% investing, you’re most likely better off investing your extra cash. Let’s look the character of both opportunity costs and understand the differences.
The Cost of Debt
The cost of debt is easy to calculate and understand. In most cases, it’s your interest rate. If your car loan’s interest rate is 6%, then the cost of not paying off that debt is 6% per year, easy. Using this example, I like to frame the notion of paying off debt like this.
“I have a $10,000 car loan at 6%. I am guaranteed to pay 6% every year. Therefore, paying off the debt is equivalent to me investing in something that guarantees me a 6% return.”
It’s a slightly different perspective, but consider this. Where can you invest in and get 6% guaranteed, no market fluctuations or up/down years.? The answer in the current market environment is nowhere.
I digress. Now let’s talk about mortgage debt and student loans. The interest on mortgage debt is, depending on whether you bought your home before or after Dec. 15th, 2017, deductible on either the first $750,000 or $1,000,000 of your mortgage. Similarly, up to $2500 of student loan interest is deductible each year if your modified adjusted gross income is below $85,000 if single and $170,000 if you’re married.
So, what is your after-tax cost of debt on a mortgage or student loan with a 6% interest rate if your marginal income tax bracket is 22%?
6.00%*(1-0.22) = 4.68%
Therefore, when answering the question “should I invest or pay down debt?” you should use 4.68% as your cost of debt, not 6%.
The Opportunity Cost of Not Investing
On the flip side of our comparison is what we could expect to earn from investing. I wish I could say it is as easy as finding a cost of debt, but this gets complicated. Of course, you’re always welcome to leave a comment or call me if you have any questions about this.
Step 1: What Could I Earn?
What you can earn will depend on what you invest in. Buying short-term government bonds will earn you much less than a large cap stock fund over the long run, so you need to know what you’re investing in. For our purposes here, I’ll simplify things and assume that everything will be invested in 100% American stocks. Historically, the average return for such a portfolio has been about 10% a year.
10%, got that? Let’s move on.
Step 2: Taxes
If it earns money, Uncle Sam probably wants his cut. Therefore, using a 22% tax bracket like in the debt example, your actual return goes from 10% to:
10.00%*(1-0.22)=7.8%
Now there are some tricks you can do here. First, you can assume that you don’t trade your investments frequently and can therefore be taxed at lower long term capital gain rates. For most people, that rate will be 15% instead of your actual tax bracket. Now, your rate of return looks better.
10.00%*(1-0.15)=8.5%
But wait, there’s more! If you are investing within a 401k, Traditional IRA, 403(b), Roth IRA, your tax treatment is different. For instance, if you are saving within a Roth IRA, your investment earnings will be tax-free. Therefore, 10% is actually 10%! The caveat with these types of accounts though is that they are retirement accounts and therefore you cannot usually withdraw your money (the rules vary specifically for each account) until after age 59.5 without penalties. And, of course, many 401k and employer retirement plans have a match.
Comparing Investing Versus Paying Off Debt – The Simple Version
What I outlined above is the simple version for deciding on whether to invest more or pay down debt. In my next article I’ll include some other factors – namely investment risk (this is very important!) and retirement account perks. I’ll also post a spreadsheet in that article so you can calculate what is best for your specific scenario. For now, however, let’s do some hypothetical comparisons with some overly idealized scenarios.
- If I can earn 10% after taxes investing or pay down my credit card with a 25% interest rate, what should I do?
- 25% is greater than 10%, so pay down the credit card
- If I can earn 6% after taxes investing or pay down my student loans at 6%, what should I do?
- In most cases, your student loan interest will be deductible, so your after-tax interest rate on your debt is lower than 6%. Therefore, you should invest.
- If I can earn 8% after taxes investing or pay down my car loan at 4%, what should I do?
- Your cost of debt is significantly lower than your expected investment return. Invest your savings.
Like I said, these are overly idealized scenarios. The concepts I go over in the next article are just as important as concepts covered here, as investment returns are usually not guaranteed (and you can lose money as well). Stay tuned for part two!