You work hard to pay off your debt and you probably feel pretty good about it. And you should feel good about it. Still, there might be a nagging thought at the back of your mind: "Maybe I should invest rather than pay off all this debt." It's a good question to ask. But how do you know when scaling back on debt payments makes sense?
In my experience, there are a few different ways to address this question and it's important to cover all your bases:
1. The Math
From a financial standpoint, it's easy to determine which way to go. Compare the cost of your debt to the expected investment return. If the after-tax cost of debt is higher than the after-tax return, pay off the debt. For example, if you have credit card debts that charge you 8% interest, it's far better to pay that off unless you could earn more than 8% after-tax.
On the other hand, if you have a low-interest mortgage which costs you 2.5% after tax it might make financial sense to hold on to the mortgage for as long as possible - or at least as long as you can earn more than 2.5% after tax.
2. The Return
It's usually no problem to calculate what your debt costs. But investment returns are another matter. Consider investing in the stock market for example. There is simply no way to know how much you will earn in the market in a year or even or any number of years. This is one reason it rarely makes sense to borrow in order to invest in the stock market.
The only exception to this rule is when it comes to retirement plans that offer a match. If your employer matches your 401k or 403b contributions dollar-for-dollar, that means you are receiving a 100% return on your money. If you have a choice between contributing to the plan and getting the match or paying off a credit card, you might be better off putting the money into your retirement plan.
3. The Risk
You have to consider risk when you hold on to your debt and invest. If you pay off a debt that costs you 8% for example, you save yourself that 8% interest - guaranteed. It only makes sense to keep that debt and invest if you can earn more than 8% with very little risk as I mentioned above.
Let's say you have $10,000. You can either pay off your home equity line of credit that currently costs you 3% or loan out your money to a person who will pay you 7%. The numbers might work if everything flows right. But what happens if the borrower flakes? You might get left holding the bag.
And the risks don't end there. Let's use the example above but let's assume the person who offers you 7% is the U.S. Government. That sounds like a sweet deal because your income and principal are guaranteed. But it still might not be a good deal for you. Here's why.
What if your home equity line of credit interest rate increases to 9%? Or what if the interest you pay stays the same but you suddenly need that $10,000 because you lose your job or need to repair your home? If you can't get more out of your equity line and you can't cash out of your investment, you are going to be in a world of trouble my friend.
So when you consider risk, think about investment risk and consider your cash flow and liquity situation as well.
4. The Emotions
There is more to life than money - but you already know that. And when you are faced with the option of paying off debt or investing you have to look inside for an answer too. Maybe the numbers do favor holding on to the debt and investing, but how does that leave you feeling?
Close your eyes and imagine how you'd feel if you got rid of that debt. Is the emotional payoff worth it? Sometimes the answer is yes. When that's the case, paying off the debt might be wise despite the fact that it doesn't pencil out.
When you are deciding between paying off debt or investing, consider the numbers, your risk tolerance and what feels right. Look for a balance and make your decision. Typically, you are better off by paying off your debt and only then start investing.
Have you ever been in a situation where you had to decide between getting out of debt faster or investing? What did you do? Why?
