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 Maybe you've got a family budget that's helping to keep you out of debt. Or perhaps your budget is working so well that you're running a surplus and finding yourself thinking about this question: Should I start paying down my debt or invest the money? Fortunately there are a couple of simple rules of thumb that can help you make the right decision.
What to Do With Extra Money?
Every day we read about the growing credit card debt problem that plagues consumers throughout America. But what if you're not one of those consumers? In fact, what if your one of the lucky ones that finds themselves with some disposable income and you're trying to figure out what to do with the money?
If you're fortunate enough to find yourself in this situation then you have three practical options:
- Begin paying down existing debt
- Start investing the money
- Build an emergency fund
Admittedly these last two options are quite similar, but as we'll explain there is at least one important difference. But first, let's figure out if it's better to save the money or pay off some existing loans or credit card balances.
Paying Down Debt or Investing
Paying down debt and investing are extremely similar concepts. When it comes right down to it you're really trying to figure out where to invest your money - the stock market, a Certificate of Deposit, mutual funds - or your debt.
That's right, when you're paying down debt it's just like investing in your debt. You can stick the money in the bank and earn 5% or start paying off a mortgage. It really is the same concept. And because that's true all we need to do is follow one simple rule of thumb:
- You always want to invest your money where the risk-adjusted, after-tax interest rate is the highest.
That's a lot to think about, so let's dive into this rule a thumb then run through a couple of real world examples to see how this works.
Risk Adjusted Rates of Return
We don't want to confuse things by getting into a deep discussion of asset performance against benchmarks so we can calculate beta and alpha values and determine risk adjusted performance. But we do want you to understand a simpler concept.
If you think that investing in the stock market or mutual funds is a guaranteed return of 10% then you're forgetting that the stock market carries with it certain risks. You might gain 10% in the next year or you might lose money too. The greater returns associated with the stock market exist because of the risk investors are willing to take with their money.
What this means is that before you run off and decide that you should invest excess money in the stock market, just realize that there are risks too. That kind of investment might not be as good a deal as you think it is and that's why our rule of thumb contains the term "risk adjusted."
After Tax Returns
When you're using this rule of thumb you want to compare after-tax returns because income taxes represent real cash flow - it is money that really leaves your pocketbook. For example if you can earn 5.4% on a money market account then the interest payments made to you are taxable. Income taxes lower the effective interest rate paid to you by the bank.
On the other hand let's say you've got a mortgage carrying an interest rate of 5.4%. Each payment you make on the loan helps to pay down the balance, or principal, and some of the money goes toward interest charges. Since mortgage interest is tax deductible that lowers the effective interest you're paying on the loan.
The important concept to remember here is that you want to compare after tax interest rates.
After tax interest rates are calculated using the following formula:
Interest Rate - (Interest Rate x Tax Rate) = After Tax Interest Rate
So if you have an interest rate of 10% and you're in the 25% federal income tax bracket, then the after tax interest rate would be:
10.0% - (10.0% x 25%) = 10.0% - 2.5% = 7.5%
The above calculations assume the interest rate your evaluating is either taxable or tax deductible. If not, then an adjustment is not necessary. Let's see how these concepts are put into practice using a couple of examples.
Example 1 - Paying off Mortgage Debt or Investing in a CD
In this first example let's say you have a mortgage carrying an interest rate of 4.875%. Furthermore let's say that a local bank is offering you 5.60% on a one year certificate of deposit, or CD. You've also got an extra $1,000 - so where would you invest for the next twelve months?
If you invested in the CD, you'd have your original $1,000.00 plus $56.00 would have been paid in interest leaving you with $1,056.00 after 12 months. Let's assume you're in the 25% tax bracket. So you'd owe an additional $56.00 x 25% or $14.00 in federal income taxes. Your net gain on this investment is $42.00.
If you took that $1,000 and paid down your mortgage, that investment would save you $1,000.00 x 4.875% or $48.75 in interest charges. But those interest charges are tax deductible, so you lose a tax deduction of $48.75. That means you've lost $48.75 x 25% or $12.19 on your tax return. You net gain on this investment is $36.56.
Example 2 - Paying off Credit Card Debt or Investing in a CD
In this second example, let's keep everything the same except now we've got the chance to pay off $1,000.00 worth of credit card debt at 16.0%.
If you invested in the CD, you'd still have a net gain of $42.00 as shown in our first example.
But if you took that $1,000.00 and paid down a credit card balance then that investment would save you $1,000.00 x 16.0% or $160.00 in interest charges over the next twelve months. In addition, most credit card debt is not tax deductible so the gain on that investment is not reduced meaning your net gain is $160.00.
Generally, interest charges for student loans, first and second mortgages and most home equity loans are deductible on your federal income taxes so that after-tax interest rate on these types of loans is usually very low.
But as this second example clearly demonstrates - paying down credit card debt many times provide the greatest rewards. Interest rates are usually quite high and the interest charges are not tax deducible - so this kind of investment had two things working in its favor.
Emergency Funds
At the start of this article we mentioned that you really had three options - and that third option was to start building an emergency or "rainy day" fund. This idea goes back to one of the old "pay yourself first" concepts. If you've never experienced complete financial freedom then you're missing out on a great feeling.
The first step most people take down the path to financial freedom is to create an emergency fund. This is money that is used for no other purpose other than helping you to make it through a short-term financial hardship such as the loss of a job. Most emergency funds consist of four to six months worth of household expenses.
Because of the intended purpose of the fund, the money is usually placed in a relatively liquid account such as a savings account or money market account. And most of the time you're going to give up something - such as higher returns on investment - in exchange for the convenience of owning an asset that be quickly converted to cash.
That being said, it's really your decision whether or not you'd like to build up an emergency fund before applying the "pay down debt versus invest" rules discussed earlier. Certainly it is an option from a financial standpoint but from a practical viewpoint an emergency fund does make life a bit more enjoyable.
About the Author - Invest or Pay Down Debt
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