Owning a home with a white picket fence is beginning to cost more than we expected, not to mention consumerism that is brainwashing us to get the latest deal on a gadget we don’t even need. Because of the way society is shaped, many of us end up in loans we never would have gotten into if it wasn’t for the normalcy we attribute to it. So now we find ourselves in the race to financial freedom, and the million-dollar question remains:
Should I pay off debt first or should I invest instead?
Although it may sound complicated at first, there really is a simple way to reaching a decision if you should pay your debts off first or if it’s time to invest for the future. It all lies in the relation between debt interest rates and return of investment. Even if you shop for the best credit card deals, usually credit cards are the debt instrument with the highest interest rate.
Let’s say you have a credit card with a balance that’s growing at an interest rate of 17.99% per year, unless you can find an investment vehicle that offers you a guaranteed interest of more than that, then that’s the only time that you should opt to use your money to invest rather than pay off your credit card debt.
Below are the steps that you can take in order to make the smart decision between investing and paying off debt.
Find Out How Much You Owe
The first thing you need to do is to understand just how much you owe, which institutions you owe your debt to, and how much is the interest rate for every loan you’ve taken. This is especially crucial for those who have several types of loans such as car loans, student loans, credit cards, and home mortgages.
Make a list of your total debt owed, the monthly payments you need to make, as well as the interest rate for each debt type. Rank your debt according to priority. The higher the interest rate, the more priority the debt should have. Another way to prioritize your debt is by monthly payment. You can list your debt from lowest to highest monthly payment. How you prioritize doesn’t matter, just make sure your prioritize your debt in a way that works best for you.
Find Avenues for Investment
The next step is to research the types of investments you are comfortable in having. Investing can be a complicated matter especially for those who have never tried it before. There are different ways to invest, and usually the ones with the highest returns also carry the highest risk.
So in order to make a smart decision whether you should pay off your debt first, or take on an investment, it’s important for you to understand the specific investment vehicle you are planning to use. This includes knowing the rate of return on the investment, the potential risks involved, and when you expect your investment to mature, among others.
Compare the Annual Return on Investment VS Interest on Debt
Now that you’ve gotten yourself familiar with both your debt and potential investment vehicle, you can start comparing which among the two have a higher rate of interest. For example, if you have a credit card debt of 9%, and a mortgage rate of 4%, but you have also found a bond that offers 8% interest, then you can opt to pay off your credit card debt, and use the rest of your money to invest in the bond rather than paying your mortgage.
Consider Tax Implications
Although checking the interest rate is a start, there are also other things to consider such as whether your investment is taxable and if the interest on your debt is tax deductible. Taxes can be complicated and can cause you to pay more than you expected, so it’s important to include this in your calculations.
There is a formula you can use when considering taxes. It’s called the tax-equivalent yield. Let’s say you’re in the 28% tax bracket and would like to determine if you should pay your student loans which have an APR of 5% or invest in a 8% bond which will be taxed at your marginal tax rate of 28%
Tax-equivalent yield = Tax-free yield / (1 – your federal tax bracket)
5 / .72 = 6.94%
This means that if your investment is being taxed at 28% you would need to make 6.94% to be equivalent to paying off your student loans which carry a 5% APR. So in the scenario above the 8% bond wins out! Keep in mind this formula does not account for risk!
Consider How You Feel
Another factor that can determine your decision is which path would give you the most peace of mind. Some people can be greatly affected by debt, causing them to lose sleep at night. Instead of making an investment, it may be better for them to pay off their debts if it makes them feel more at ease. There are also others who don’t feel financially secure without proper investments. So consider how you feel, but also be smart about your decisions.
The way to financial freedom is being smart about balancing out the factors that affect the way money is working for you. Making the decision to either pay off your debts first or invest for the future isn’t as complicated as it seems to be. It’s just composed of careful planning, research, and of course, discipline.