People who find themselves with extra cash often face a delicious dilemma: Should they use the windfall to pay off—or at least, substantially pay down—that pile of debt they've accumulated, or it is more advantageous to put the money to work in investments that'll build up a nest egg? In order to decide whether to pay down debt or invest, you must consider your best investment options, risk tolerance, and cash flow situation.
The After-Tax Costs
All debt is not equal. The type of debt you have can play a role in the decision as to whether to pay it off as soon as possible or put your money toward investments.
From a numbers perspective, your decision should be based on your after-tax cost of borrowing versus your after-tax return on investing. Suppose, for instance, that you are a wage earner in the 35% tax bracket and have a conventional 30-year mortgage with a 6% interest rate. Because you can deduct mortgage interest (within limits) from your federal taxes, your true after-tax cost of debt may be closer to 4%.
Student loans are a tax-deductible debt that can actually save you money. The IRS allows you to deduct the lesser of $2,500 or the amount you paid in interest on qualified student loans that were used for higher education expenses, although it phases out at higher income levels.
If you hold a diversified portfolio of investments that includes both equities and fixed income, you may find that your after-tax return on money invested is higher than your after-tax cost of debt. For example, if your mortgage is at a lower interest rate and you are invested in riskier securities, such as small-cap value stocks, investing would be the better option. If you're an entrepreneur, you also might invest in your business rather than reduce debt. On the other hand, if you are nearing retirement and your investment profile is more conservative, wiping the slate clean may be a better option.
How do I Save and Invest with Debt? Nashville
Risk Tolerance in Investing
After you've looked at the after-tax costs of borrowing, consider the potential returns of investing. While that can't be predicted exactly, of course, you can get a rough sense from your tolerance for risk.
Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. When determining yours, consider the following:
- Your age
- Earning power
- Time horizon
- Tax situation
- Any other criteria that are unique to you
For example, if you're young and able to make back any money you might lose and have a high disposable income in relation to your lifestyle, you may have a higher risk tolerance and be able to afford to invest more aggressively versus paying down debt. If you have pressing concerns, such as high health care costs, you may also opt not to pay down debt but opt to earn more instead.
Rather than investing excess cash in equities or other higher-risk assets, however, you may choose to keep greater allocations in cash and fixed-income investments. The longer the time horizon you have until you stop working, the greater potential payoff you could enjoy by investing rather than reducing debt, because equities historically return 10% or more, pretax, over time.
A second component of risk tolerance is your willingness to assume risk. Where you fall on this spectrum will help determine what you should do. If you are an aggressive investor, you will probably want to invest your excess cash rather than pay off debts. If you are fairly risk-averse in the sense that you cannot stand the thought of potentially losing money through investing, you may be better off using the cash flow to eliminate all those outstanding balances.
The operative word, though, is "eliminate." While most investors think paying down debt is the most conservative option to take, paying down, but not erasing debt, is a strategy that can backfire. For example, an investor who aggressively pays down his mortgage and winds up with meager cash reserves may regret his decision should he lose his job and still need to make regular mortgage payments.
Building a Cash Cushion
Financial advisers suggest that working individuals have at least six months' worth of monthly expenses in cash and a monthly debt-to-income ratio of no more than 25% to 33% of pretax income. Before you begin investing or reducing debt, you may want to build this cash cushion first, so that you can weather any rough events that occur in your life.
Next, pay off any credit card debt you may have accumulated. This debt usually carries an interest rate that is higher than what most investments will earn before taxes. Paying down your debt saves you on the amount that you pay in interest. Therefore, if your debt-to-income ratio is too high, focus on paying down debt before you invest. If you have built a cash cushion and have a reasonable debt-to-income ratio, you can comfortably invest.
Keep in mind that—as we noted earlier—some debt, such as your mortgage, is not bad. If you have a good credit score, your after-tax return on investments will probably be higher than your after-tax cost of debt on your mortgage. Also, because of the tax advantages to retirement investing, and given the fact that many employers partially match employee contributions to qualified retirement plans, it makes sense to invest versus paying down other types of debt, such as car loans.
A Strategy for the Self-Employed
If you are self-employed, having cash on hand may mean the difference between keeping your independence and having to go back to work for someone else. For example, suppose that an entrepreneur with a fairly tight cash flow gets an unexpected windfall of $10,000, and she has $10,000 in debts. One obligation carries a balance of $3,000 at a 7% rate, and the other is $7,000 at an 8% rate.
While both debts could be paid off, she has decided to pay off only one, in order to conserve cash. The $3,000 note has a $99 monthly payment, while the $7,000 note has a $67 monthly payment. Conventional wisdom would say she should pay off the $7,000 note first because of the higher interest rate.
In this case, however, it may make sense to pay off the one that provides the greatest cash flow yield. In other words, paying the $3,000 note off instantly adds nearly $100 a month to her cash flow, or almost 40% cash flow yield ($99.00 x 12 ÷ $3,000). The remaining $7,000 can be used to grow the business or as a cushion for business emergencies.
Balanced Budgeting Methods
There are a number of different budgeting methods that allow for both debt repayment and investments. For instance, the 50/30/20 budget sets aside 20% of your income for savings and any debt payments above the minimum. This plan also allocates 50% to essential costs (housing, food, utilities), and the other 30% for personal expenses.
Financial advice author/radio host Dave Ramsey offers a back-and-forth approach to tackling debt and investments. He suggests saving $1,000 in an emergency fund before working to get out of debt, excluding your home mortgage, as quickly as possible. Once all debt is eliminated, he advises returning to building an emergency fund that contains enough money to cover at least three to six months of expenses. Next, his plan calls for investing 15% of all household income into Roth IRAs and pre-tax retirement plans while also saving for your child's college education, if applicable.
The Bottom Line
Knowing whether to pay down debt or invest depends not only on your economic environment but also on your financial situation. The trick is to set reasonable financial goals, keep your perspective, and evaluate your investment options, risk tolerance, and cash flow.
Take a look at your personal finances to determine where your money will make the most impact. If the hard math doesn't help you to decide between one or the other, try tackling both at the same time, or else put your focus on the financial goal that will give you the most peace of mind.