The most common question I receive is “Should I pay off my debt or should I start investing?” The answer is, as most my answers are, it depends. It depends on many factors such as your debt type, interest rate, risk tolerance and your attitude towards debt. Paying mortgage vs. saving for retirement is an ongoing debate I don’t see an end to it anytime soon. The most common advice is to pay off your consumer debt (credit cards and car loans) then start investing while paying down your mortgage and student loans. The rule of thumb is that the after tax return on your investment should be better than the interest rate you are paying on your debt. This is a good rule of thumb to use, but it only captures the math in the process and leaves out the emotions and psychology of the individual. Works well in some cases and not so much in other cases, I am not talking about the math component of it.
So what should I do? My answer is do what you are comfortable with.
1. List Your Debt with Interest Rates
Grab a paper and pen and write down all your debt, everything. Now rank them with the highest interest first and so on, use effective interest rates if it is tax deductible. Also include the term length if there is one. You should have a neat list with all your debt in order from highest to lowest.
2. Budget and Emergency Fund
Before going ahead ensure you have established a budget and are not running a deficit. Also make sure you have a sufficient emergency fund (6 months worth of expenses is a good place to start). It’s important to have these two in place before you start investing, because if you are running a negative budget you will be in trouble soon and an emergency fund will protect you and your investments in case of an emergency.
3. Do Some Math
Now it’s time to do some math, yea the fun part J! Look at your effective interest rates and see if you can earn more than that AFTER taxes in your investments. Example:
You have a $15,000 balance on a credit card with a 20% annual percentage rate. Credit card interest expense is not tax deductible, which means that you should only invest IF you can get better than 20% annual return. Looking at the market history the average annualized return is about 10-12% per year.
Therefore, it does not make any sense to invest if this is the case. As a rule of thumb you should always pay off your credit card debts before investing, the interest rates on credit cards and department store cards are astronomical. Look at paying your credit card debt down as investing, you are getting a guaranteed 20% return on your money, you will never see such guaranteed return. How? By paying down the debt you are saving 20% that you would have otherwise paid in interest – which is now in your pocket.
Let’s look at a different example, where it may make sense to invest.
Assume you have a twenty year, $200,000 mortgage with a six percent rate. For simplicity sake we assume you are in the 25% tax bracket. In the US your mortgage interest can be tax deductible so in this case your effective interest rate will be about 4%, in Canada we are less lucky and our mortgage is NOT tax deductible so our effective interest rate will be about 6%.
In this case you expect to earn an after-tax return higher than 6% (or 4% if mortgage is tax deductible) on your investments then you should invest. If you have a well diversified portfolio than your chances of beating this rate are very good.
So we did the math and know when to invest and when to pay down debt, but there is more to our thought process than just math. Nobody can answer this question but yourself, how do you feel about debt? Some people hate debt, others don’t mind debt so much. Which group do you belong to? Maybe you want to reduce your debt load before investing even though the math says you should invest now. What is your attitude towards debt? If you want to reduce debt than set up a debt reduction plan and work aggressively towards it, otherwise you will never be able to invest and save for retirement.
Bottom line: Look at all the angles and do your math, but do NOT forget your emotions and attitude towards debt. Do what you are most comfortable with; there is no point in investing and not being able to sleep at night.
Do you pay down your debt or invest? What was your thought process in reaching your decision? Any tips or tricks – please share.
Ray is an ex-financial adviser and the founder of Financial Highway. Currently working in the financial industry and working towards completing his Chartered Financial Analyst, CFA, designation.