Invest or pay off a debt?

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

The 6% rule

To make this analysis as simple as possible, be sure to follow this rule: If your debt costs you (which means the interest rate you pay is) 6% or more, you should always pay the debt before investing. A 6% return is a conservative number to expect from the stock market. Many experts will say that historically the market has profited 8-10% per year. While I don’t disagree with those experts, no one can predict the future. We don’t 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 must ask yourself this: How comfortable are you carrying your debt? This question is not limited to asking if you can make your monthly debt payment, although that is part of the question. Most of the question is wondering if you can handle your debt emotionally. Is Your Debt Burden Keeping You Up At Night? If you answered yes, then you are not comfortable with your debt and must pay it off. If you worry at random times about your debt, again, you are not comfortable with your debt and must pay it off. If none of these scenarios describe you, then you may want to go a step further and really analyze whether it is better to invest or pay off your debt.

The decisive formula

To determine which one is right for you, you will need to do a little math. But don’t worry, the math is not difficult. The first step is to take your debt (in this case, you will calculate each debt you have separately) and compare it to your investment tax return. In this first example, we’ll assume you have $ 5,000 in 4% credit card debt. Since you cannot write off the interest you pay on your taxes, we do not need to calculate the after-tax cost of debt. For all debts that you cannot pay interest on, the rate you pay is your after-tax cost. In this case, 4%. Next, we will assume that you are 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 taxes, you made 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 highest return you get is only a percentage. It’s worth it? This is where we go back to what matters most to you? Technically speaking, in this example, the difference is not material, which means it is too small to matter. Whichever option you choose, it is the right option for you. After all, personal finances are 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 of 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 will 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 investing example above). In this case, you should pay your mortgage instead of investing.

If you go through this process and the answer you come to is investing and after a few months you have doubts, then of course, stop investing and pay off your debt. That restlessness you feel is your instinct that tells you that this is not right. Listen to your instincts.

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

conclusion

To recap, if any of your debts exceed 6%, there is no math involved. You better pay off your debt. At the opposite extreme, any debt that is 2% or less, you must invest your money. You can easily earn more than 2%, even in bond funds. It would be better to invest rather than pay off the debt. Of course, this also goes back to the previous point that personal finances are personal. If you still prefer to pay off the 2% debt, go ahead.

For any debt that is between 2% and 6%, you need to do the quick calculations above to come to a conclusion.