The one financial question that everyone wants to know the answer to is: Am I better off investing my money or paying off debt? The answer is not as hard as one would assume. Although, 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 costs you (meaning the interest rate you pay is) 6% or more, you should always pay off 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 returned 8-10% per year. While I do not disagree with those experts, no one can predict the future. We do not know what the market will do going forward. 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 that you have that is less than 6%? This answer can be easy as well. You must ask yourself this: how comfortable are you in carrying your debt? This question does not simply ask if you are able to make your monthly debt payment, although that is part of the question. The bigger part of the question is asking yourself if you are able to handle carrying debt emotionally. Does the debt load keep you up at night? If you answered yes, then 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 should pay it off. If neither of these scenarios describes you, then you may want to take a step further and truly analyze if you are better off investing or paying off your debt.
The Deciding Formula
To determine which is right for you, you will have 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 that to your after tax return on investing. In this first example, we will assume you have $5,000 in credit card debt at 4%. Since you cannot write off the interest you pay on your taxes, we do not need to calculate your after-tax cost for the debt. For all debt that you cannot write off the interest, 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-tax, you earned 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 since you earn a higher return.
But, the greater return that you earn is only of a percent. Is that worth it? Here is where we go back to what matters to you more? Technically speaking, in this example, the difference is not material, meaning it is too small to matter. Whichever option you choose, it’s the right choice for you. After all, personal finance is just that, personal. You decide what is best for you and your situation.
Now let us assume you have a mortgage at 6.50%. Since the interest you pay on this debt is tax deductible, we have to complete the calculation for both 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%. Effectively, your after-tax cost of you mortgage is 4.88%. By investing, you will earn 4.5% (as seen 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 come to is to invest and after a few months you are having second thoughts, then by all means, stop investing and pay off your debt. That uneasiness you feel is your gut telling you this isn’t right. Listen to your gut.
If you have multiple sources of debt, simply perform this calculation for each one that has an interest rate under 6%. You can then see which debts you should pay off and which ones you should pay the minimum and invest instead.
To recap, if any of your debt is over 6%, there is no math involved. You are better off paying the off your debt. On the opposite end, any debt that is 2% or less, you should invest your money. You can easily earn more than 2%, even in bond funds. You would be better off investing rather than paying down the debt. Of course, this also goes back to the earlier point that personal finance is personal. If you would still rather pay off the 2% debt, go for it.
For any debt that is between 2-6%, you need to do the quick math above to come to your conclusion.