Should you invest money or pay off debt? This is a common question that new clients ask us. There are two basic factors involved in answering this question: the mathematical factor and the psychological factor. Here’s what you need to know.
The Mathematical Factor
Every person’s situation is unique, but there are a few areas to look at, including:
- The expected rate of return for investments. This rate of return will be based in part on your willingness to take on risk
- Current Interest rates in the market in general, and the interest rates of your debt in particular
- The type of debt you have and the associated tax benefits (if any)
- Whether your employer offers matching contributions to your retirement account
- If you have private mortgage insurance on your primary residence
- Your income variability
- How many sources of income your household has
- How far away from retirement you are
An analysis of the variables listed above can guide you to an optimal solution mathematically.
The basic idea is to pay down any debt that has an after-tax interest rate that is more than the expected after-tax rate of return on your investments. Then invest in the most tax-efficient manner. There does not exist one approach that will be the best for every situation. Nevertheless, here is a rubric to determine if you should invest money or pay off debt.
- Contribute enough money to your company retirement plan to ensure you receive the full amount of the company’s matching contributions.
- If you have debts with interest rates that are higher than your expected rate of return on your investments, pay off these debts next. Prioritize paying off debts where the interest payments are non tax-deductible (like credit cards) over debts where the interest payments are tax-deductible (like student loans).
- Contribute the maximum to your tax-advantaged investment accounts. These might include a 457, a 401(k), or an IRA.
- If you have debt that requires you to maintain private mortgage insurance, pay off that debt next.
- Contribute to non-tax-advantaged investment accounts (i.e., brokerage accounts), and invest in assets that are expected to provide returns that are greater than the interest rate on the rest of your outstanding debt. Bonus tip: ensure that the investments themselves are tax-efficient.
- Pay down any remaining debt you may have.
The Psychological Factor
The above approach to the question, “should you invest money or pay off debt?” gives you the mathematically correct answer (allowing for the fact that there are variables that are unique to each situation, and these variables can alter the results of the rubric above).
However, psychological factors play a large role in investing. We can’t cover all of these factors, but here are a few that will impact the decision of investing or paying off debt.
Some individuals do not like the idea of having debt. Perhaps they don’t believe that debt is ethical. Perhaps holding debt is contrary to their religious beliefs. Perhaps the feel that debt holds them under someone else’s power. There are many personal feelings and beliefs about debt. These feelings and beliefs might be strong enough to motivate a person to focus on paying off debt before investing.
Other individuals might strongly value having cash on hand in case, for example, there is an emergency that requires money, or perhaps there is an opportunity that might come their way that requires a cash investment. In this case, they might choose to continue to carry debt.
Conclusion: Invest Money or Pay Off Debt
Investing is always more than just math. Emotions, beliefs, feelings, and other psychological factors are also at play. Wise financial management requires one to be able to honestly assess their math and their psychology.
A fiduciary financial advisor can be an excellent source of guidance when it comes to making these choices and creating an intentional, organized strategy that fits your financial goals.