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Invest or Pay Off Debt?

The one financial question that everyone wants to know the answer to is: should I invest my money or pay off my debts? The answer is not as difficult as one might suppose. However, it can get murky, 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 is costing you (i.e. the interest rate you are paying is) 6% or more, you still owe repay 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 returned 8-10% per year. Although I don’t disagree with these experts, no one can predict the future. We don’t know what the market will do in the future. Accordingly, I will be conservative and use 6% as the average market return per year.

Now, what do you do with any debt below 6%? This answer can also be easy. You have to ask yourself this: how comfortable are you with taking on your debt? This question is not simply asking if you are able to make the monthly debt payment, although that is part of the question. The biggest part of the question is asking yourself if you are able to manage your debts emotionally. Is debt keeping you up at night? If you answered yes, you are not comfortable with your debt and you should pay it off. If you worry at random times about your debt, again you are not comfortable with your debt and you should pay it off. If none of these scenarios describes you, then you might want to go deeper and really analyze whether it’s better to invest or pay off your debt.

The decisive formula

To figure out what’s right for you, you’ll need to do a bit of 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 return on investment. In this first example, we’ll assume you have $5,000 in credit card debt at 4%. Since you can’t deduct the interest you pay on your taxes, we don’t need to calculate your after-tax cost of debt. For all debt for which you cannot write off interest, 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 obtained a return of 4.5% on your investments. Compare that to the 4% you pay in credit card interest. Mathematically, you are better off investing your money since you earn a higher return.

But, the biggest return you earn is only one percent. Is it worth it ? Here’s where we come back to what matters most to you? Technically speaking, in this example, the difference is not material, that is, it is too small to matter. Whichever option you choose, this 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 suppose you have a 6.50% mortgage. Since the interest you pay on this debt is tax deductible, we need to calculate the after-tax cost of the debt and the after-tax cost of the investments. We will assume the same facts as above regarding the 25% tax bracket. Here you will take the 6.50% interest from your mortgage and multiply it by 1 minus your tax bracket. The formula is .065(1-.25). The answer is 4.88%. In fact, the after-tax cost of your mortgage is 4.88%. By investing, you will earn 4.5% (as shown in the after-tax investment example above). In this case, you should pay off your mortgage rather than invest.

If you go through this process and the answer you arrive at is to invest and after a few months you have doubts, then stop investing and pay off your debt. This discomfort you feel is your instinct telling you that it 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 below 6%. You can then see which debts you should pay off and which you should pay the minimum and invest instead.

Conclusion

To recap, if any of your debts exceed 6%, no calculation is necessary. You better pay off your debt. In contrast, any debt of 2% or less, you must invest your money. You can easily earn more than 2% even in bond funds. You’re better off investing than paying off debt. Of course, this also goes back to the previous 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 come to your conclusion.

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