This time of year, people often find themselves with a small windfall from tax returns. Often they want to know whether it’s better to pay off debt or invest extra cash. It depends. It depends on a variety of factors, your personal situation, and your personality. But I’ll outline 5 considerations that hopefully will help you make a wise decision.
1. Interest Rate of the Debt vs. Return on Investment
The interest rate on your debt is likely the most important factor in your dilemma. If your debt’s interest is above 7%, stop right here. As long as you already have an emergency fund (see step 4) get rid of your high interest debt. Otherwise you’d be paying more in interest than you’d be able to earn on an investment. On the other hand, if all your debt carries lower interest rates, you may decide to continue making minimum debt payments and investing your extra cash. Just be sure that your investments will return more than the interest on your debt.
2. Tax Implications
Different kinds of debt and investments affect your taxes differently. If you have enough tax deductions to itemize ($6,300 for singles, $12,600 for couples), your mortgage serves as a tax write-off. The mortgage write-off is a terrible reason to go out and buy a big house with a big mortgage. But if you already have a reasonable mortgage with a low interest rate, the write-off may be reason to hang on to your mortgage and invest your cash instead. Of course, continue to make minimum payments on your mortgage.
Most other debts don’t offer any tax deductions. Paying down these debts is basically a tax free investment.
Different investments also receive different tax treatment. If you invest in a retirement account, municipal bonds or federal savings bonds, your investments don’t incur any tax liability. In fact, depending on your income, investing in a retirement account might even earn you the savers credit on your next return. But if you are just investing in traditional investments in a regular investment account, taxes can take a bite out of your investment returns. Because of the taxes that you’d owe on traditional investments, paying down debt may be a better option, even if the debt carries a lower interest rate.
3. Some Returns are More Equal than Others
Some investments are steadier than others. If you invest in the stock market, you might not actually see a return on your investment for several years. In fact, you might go through an extended period of loss. With more conservative investments, your returns are more guaranteed. These riskier returns may be an issue if you may need to access your investments in the nearer future, or if you simply won’t be able to stomach the roller-coaster ride of the stock market.
Paying down debt gives you a guaranteed return. Every dollar you throw at your debt is one more dollar you don’t have to pay interest on, and 1.X less dollars (or maybe even 2 dollars less) you’ll owe on the debt in the future.
4. How Will Your Resilience Be Affected?
It’s always important to think not only in today’s context, but also tomorrow’s context. Nobody knows what kind of sunny or rainy day tomorrow will bring. How ready are your finances for unexpected expenses or a drop in income? If you don’t have an emergency fund and are living paycheck to paycheck, put a large portion of your windfall in low risk savings such as a high yield savings account. You should always aim to have at least a $1000 cash buffer.
If you’ve got this cash buffer in place, paying down debt and investing will both affect your resilience differently. On the one hand, if you invest your money in a non-retirement account, you can always sell your investment if you need to. But you might be stuck selling at a loss. Once you make a debt payment, you can’t ‘withdraw’ without taking on more debt. On the other hand, completely paying off a debt increases your cash flow (the difference between your income and expenses), which by far makes you more resilient to hard times. I don’t think anyone ever regrets not having a monthly payment.
5. Less Debt = Simplicity
Often, investing vs debt-payoff boils down to the difference of a handful of dollars per year. You may decide it’s worth sacrificing a higher return for a simpler financial picture. Juggling investments and a handful of debt payments, along with all the extra tax paperwork may just not be worth the few extra dollars you’re squeezing out. There’s no question that holding debt complicates your finances.
The Choice is Personal
If you are holding high interest debt, such as credit card debt, the math is simple: pay it off and avoid it like the plague from this point on. However, if your only debt is low-interest debt, the choice is more personal. You may have concluded that no debt is good debt. Or you may figure that responsibly holding low-interest debt gives you leverage to earn more.
If you decide that paying down debt is your smartest move and you have multiple debts, you may find yourself trying to decide between the snowball and avalanche debt pay-down strategies.
And as a Recap:
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.