A common dilemma in personal finance is whether to use funds to pay down debt faster or to invest more. The question crops up in various forms:
- Should I pay off all credit card debt or make smaller payments while saving more for retirement?
- Should I pay extra on my mortgage or invest in securities?
- Should I pay down my student loans faster or invest more?
Financial health requires both savings and control over debt. But when these two goals seem to be in conflict, what’s the best way to balance them? Consider these six ways to prioritize.
- Make sure you get your employer match. If you’re lucky enough to have an employer that matches your contributions to the workplace 401(k) plan, your first priority is to maximize the employer match. It’s too good to pass up. Contribute any less than what’s matched, and you’re refusing the offer of free money.
- Tackle costly credit card debt. Once you are saving enough to secure your entire employer match, you can focus on paying down debts faster. The goal is to pay off all credit card debt as quickly as possible. The interest rates on credit card debt are typically so high that nothing else you do with your money is likely to be as profitable.
- Beef up your emergency fund. When you’re beyond the hurdle of credit card debt, consider building out your emergency fund. If you don’t have sufficient emergency savings to cover a serious car repair, a trip to the emergency room or other not-so-infrequent disasters, this is the next focus.
- Save enough in retirement accounts. Assuming you have no credit card debt and decent emergency savings, you can move on to the next set of priorities. If you are saving less than 10% of your pretax income in retirement accounts, ramping up your contributions is probably a better bet than paying extra on your student or auto loans or mortgage. Contributions to retirement accounts are tax advantaged, and it is almost impossible to catch up if you delay retirement savings.
- Decide whether to save more or pay down your mortgage. Only when you have no credit card debt, a healthy emergency fund, and you’re saving at least 10% of your pretax income should you consider making additional investments or speeding up your mortgage payments.
But when you compare the cost of having a mortgage to the possible returns from investing elsewhere, don’t forget the tax deduction on mortgage interest. Because of that deduction, your effective (after-tax) interest rate on your mortgage is lower than your actual mortgage rate. There are handy online calculators that can quickly calculate the effective interest rate on your mortgage, accounting for tax benefits.
If you are confident that you can invest at a rate of return that’s at least as high as your effective mortgage rate, you may want to hang on to the mortgage and invest more. Over the past few years, many consumers have taken out mortgages with effective interest rates of 3% or less. At this level of interest, there are investment alternatives that make more sense.
Also remember that extra principle payments come with liquidity risk. That is, if you need a source of cash, it may be easier to sell a security investment. To take cash out on your mortgage, you will have to refinance or open a line of credit. Either of these may come with a higher cost than your current mortgage, not to mention origination fees.
- Decide whether to save more or pay down college debts. If your income is below $75,000 per year ($155,000 for a couple filing jointly), some or all of the interest that you pay on college loans may be tax deductible. So the effective rate of interest on your college loans may be lower than the actual rate. Take that into account when you compare your loan interest with potential investment earnings.
An additional consideration may be whether a parent or grandparent cosigned your student loans. If you become disabled or die—or you’re simply unemployed for a long period of time, your consignors may have to pay your college loans. That risk may make it worthwhile to pay off college loans faster.
Accounting for Uncertainty
If you could be sure that you’ll never lose your job and that you’ll always be able to open a low-cost line of credit, the decision to pay off debts would be much easier. But you have to look beyond comparing interest rates on debt to the expected returns from investments. You have to consider that credit may not always be available at today’s rates.
With mortgage rates as low as they are now, paying down a mortgage does not look like the most attractive choice. Once you’ve paid off all high-cost revolving credit (e.g. credit cards), have a solid emergency fund, and you’re saving 10% of your income in retirement accounts, however, it’s worth considering paying down college debts.
Putting non-retirement money into risky investments like stocks before you have accomplished the milestones listed above makes your overall financial situation more risky. Whether or not this is too much risk depends on you.
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