Many people come to a point in their life where they need to know whether it would make sense for them to pay down debt or invest for their future. Most people automatically assume the answer is pay to down debt. In fact, many people go as far as taking money from their retirement accounts to do so. But are they doing the right thing? Many would argue just getting the debt off of their shoulders is worth the price and hit to to their retirement accounts, regardless the overall impact to their ultimate goal, retirement. But does it make financial sense to their bottom line?
This article will look at a couple of people in different situations; First, I will look at the person whom has already built a retirement account, and has since taken on some debt, and help them decide if using retirement funds or a loan to pay down debt makes sense; Second, I will look at a person who has yet to start a retirement account, who has some debt, and whether it would make more sense for them to pay off their debt first, or get started investing immediately, and payoff the debt down the road. The following will merely teach you how to analyze what is better for you, because no one’s situation is the same.
Let’s take a look at a guy we’ll call Fred. Fred is 50 and has built himself a small yet substantial nest egg of around $100,000 for retirement. Fred’s home is nearly paid off with just a couple of years remaining on his note, and he owes around $15,000 before his home is owned free and clear. However, over the past couple of years Fred’s wife Helen had lost her job, and to supplement her lost wages, they’ve built up a bit of credit card debt, around $20,000 worth. Fred wants to know what he should now do, take a loan from his 401k to payoff the credit card debt, or continue to invest and pay down the credit card debt as he can, or maybe even do something like pay down his mortgage note before investing any more (because Fred realizes his interest on his mortgage is tax deductible).
In analyzing Fred’s situation it is critical to understand the interest rates he is earning on his investments, and what the interest rate would be on a loan from his 401k or similar personal loan from his bank, and what his interest rate is on his mortgage. Any shift in an interest rate on either an investment or debt will have a great impact on his decision. Let’s get down to a couple of examples to illustrate Fred’s dilemma.
Fred’s situation, Example 1:
- Fred has become a more conservative investor as he is nearing retirement, his investments are netting him around 8% return per year now.
- Fred has great credit, his mortgage note has an interest rate of 5.5%, while his credit cards carry a 7% APR.
- Fred qualifies for a personal loan (not tax-deductible) amount equal to payoff whatever he needs and the interest rate is 6%. He also qualifies for a home-equity loan at around the same 6% (this is tax-deductible).
Fred should consider his after-tax cost of borrowing as it compares to his after-tax return on investing to see what makes sense for him (Keep in mind this is an extremely simplified example, your situation may be much more complex and you may need the help of a professional planner or similar):
- In this particular situation, if Fred were to decide to payoff debt via a home equity loan, his balance on his mortgage note would increase, while his after-tax cost of debt would actually only be around 3.5 to 4.5%, because he would be able to deduct his interest on the mortgage. While this sounds great, keep in mind Fred will have to lower or stop the amount he is able to invest in order to pay the additional principal he has incurred to his mortgage note. So, say Fred was investing $500 per month for a total of $6000 per year, Fred would have to cease his investments for several years that he was making 8% on. In this situation, after considering Fred’s after-tax returns on his investments compared to his after-tax returns on investments (his income tax bracket will be lower after he retires), he would still be better off investing rather than paying off debt.
- Now, if Fred we’re making only 5% return on investments, and his after-tax cost of debt were higher, it would probably make sense for him to pay down debt now.
Moving on to the younger or newer investor and an example to help illustrate this same point once more, let’s take a look at another investor whom we’ll refer to as Andrew.
Andrew just graduated from college and landed his first job as a Biologist. Everything is joyous until Andrew starts filling out his work forms, and he is faced with the decision of if he should invest and how much, or pay down some credit card debt first that he accumulated while discovering all of the fascinating micro-brews in his college town. Andrew, being young, knows that if he were to start investing right away he would expect return of around 10% (this is the historical average of equities or stocks over a typical investors lifetime), however, he is also facing the reality that he has to pay down that credit card debt that he is paying about 8% APR on.
Andrew’s situation, Example 2:
- Andrew would earn 10% after-tax on his investments.
- He owes 10,000 with an APR of 8%.
- Andrew rents a place until he earns more and can afford a mortgage payment.
- Andrew would be better off investing and earning 10% while paying down his credit card debt. This of course is true if Andrew is disciplined enough to not take on additional debt, and can find a percentage of his pay to be invested while keeping the ability to payoff debt as to ultimately eliminate it over a few years. Unfortunately, Andrew’s cost of debt is relatively high, because he cannot deduct mortgage interest, however, he is still making more with that money by investing, instead of paying down debt. If Andrew’s credit card interest rate would have been higher than 10%, it would have made sense for him to first tackle his debt, then begin investing.
A few additional points to keep in mind and summaries of this article are the following:
- Investing pre-tax lowers your taxable income and could potentially drop you into a lower tax rate, consider your tax-rate as well when making this decision.
- Consider building an emergency stash of cash even before you pay down debt or invest. Things may seem all great, but then unforeseeable economic disasters can hit like the current recession, and you could lose your job. Having a stash on hand could help you meet current debts before hurting your credit score and allowing you to find another job.
- Keep in mind that many companies offer matching contributions, so by not investing, you could be missing out on free money.
- Some debt like mortgages is good. You may find your cost of borrowing is actually lower when you have a mortgage note in good standing. Not to mention, mortgage interest is tax-deductible.
I hope this article gets you thinking and on track to making the best decisions for your future. Did you find this article interesting? If so, please check out some more of my work – here are some below that I recommend that may relate to the above subject: