You’ve got extra cash! Maybe it’s from a raise, a bonus, or cutting expenses. Now, you want to improve your financial fitness but aren’t sure whether you should aggressively pay down debt or invest it.
Like most topics in personal finance, the correct answer is “it depends.”
There is good news -neither option is wrong. Both are much better for your wealth than an Amazon shopping spree or rushing out to buy a new car.
You should not make your choice based on “one-size-fits-all” advice that a guy on the radio prescribes, but rather your family’s situation, values, and goals.
Here are a few factors to consider when making your decision:
First – what’s the interest rate on the debt?
Credit cards typically have rates of 15 – 25%, whereas a 30-year mortgage rate could be sub-3%. Compare that to an investment portfolio expected to generate 7-10% annually over the long term.
Borrowing money at credit card rates and investing to earn a lower return doesn’t make sense. In this case, you’re better off directing every dollar you can toward extinguishing that debt. An exception would be investing up to your employer match in a retirement plan like a 401(k) or 403(b) since that match is “free money.”
On the other hand, a low-interest mortgage is a reasonable debt to pay the minimum on and carry as long as possible. The interest on this debt is tax deductible (only relevant if you itemize on your tax return). Sensible investments earn more than 3% over the long term, so you’re essentially borrowing at a low rate to invest at a higher rate.
If you have a cash reserve beyond an adequate emergency fund, consider using the surplus to pay down your highest interest debt. Checking and savings accounts historically pay low rates and you can often “earn” a higher rate by reducing debt instead of letting cash sit idle.
Remember that investment returns are volatile
Investment returns are not guaranteed.
That’s why they generate higher returns than cash over the long-term – because you’re willing to accept uncertainty. There can be long stretches with negative returns, and history has produced a few periods when you’d have been better off paying off your mortgage than investing.
Paying off debt – even low-interest debt – provides a guaranteed return and can offer peace of mind.
I’ve never heard anyone say they regret paying off their mortgage early.
Carrying zero debt can also make it easier to swing life transitions like a career change, sabbatical, or early retirement.
Think beyond debt interest rate vs. investment ROI
Comparing the interest rate on your debt with investment returns is a simple method. Those approaching retirement have additional variables to consider – how much will they need to withdraw from investments every year to cover debt payments? And what does that mean for the bottom line?
A retiree with $1,500/month mortgage payments will need to raise $18,000 more from *somewhere* than if their house were paid off.
That $18K would typically be withdrawn from their portfolio.
Depending on the account type(s) that are pulled from, this could require a $22K+ withdrawal (and increase to taxable income) to cover the taxes and $18K proceeds.
Larger withdrawals in retirement can mean:
- A higher effective tax rate
- More portfolio depletion during down years
- Higher tax rates on Social Security income or dividends/capital gains
- Less room in the current bracket for strategic Roth conversions, tax gain harvesting, etc.
- Higher AGI/MAGI which affects shadow taxes like IRMAA (Medicare surcharge), ACA premium tax credits, and deduction/credit phase-outs
Retirees should work with a competent financial planner that understands long-range tax planning. They can look at the overall situation and advise on impacts of carrying debt versus paying it off early.
You may have trouble deciding on if you should prioritize paying off debt or investing. Remember – it doesn’t have to be a binary decision. There’s always the option to split your cash and tackle both goals.
Personal finance is always personal, so choose the option that aligns with your family’s values and objectives!
