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Should I Pay off Debt or Invest Extra Cash?

It depends on your budget, income, and goals.

Paying off Debt vs. Investing Further: An Overview

People who find themselves with extra cash often face a dilemma. Should they use the windfall to pay off—or at least, substantially pay down—that pile of debt they’ve accumulated, or it is more advantageous to put the money to work in investments that will build a nest egg? Both options are important.

Investing is the act of setting aside money that will, itself, earn a profit and grow. Investing is not the same thing as is pure savings, where the money is set aside for future use. When you invest, you expect the money to return some income and increase the original amount. Investing provides the peace of mind that you will have funds available to endure a future financial milestone. Retirement, business projects, and paying for the college education of a child are examples of such financial milestones.

Debt refers to the action of borrowing funds from another party. Some of the most common debts include borrowing to purchase a large item such as a car or a home. Paying for education or unplanned medical expenses are also common debts. However, a debt many people struggle with every month is credit card debt. According to research from the Federal Reserve Bank of New York, credit card debt ended 2020 at a record of US$930 billion.   How to go about paying off debt is a problem many people worry about every day—it is also a problem many lose sleep over every night.

Investing Funds

Investing is the act of using money—capital—to make returns in the form of interest, dividends, or through the appreciation of the investment product. Investing provides long-term benefits and earning an income is the core of this endeavor. Investors can begin with as little as $100, and accounts can even be set up for minors.

Perhaps the best place for any new investor to begin is talking to their banker, tax account, or an investment advisor who can help them to understand their options better.

Types of Investments

There are many products that you can invest in—known as investment securities. The most common investments are in stocks, bonds, mutual funds, certificates of deposit (CDs), and exchange-traded funds. Each investment product carries a level of risk and this danger connects directly back to the level of income that a particular product provides.

CDs and U.S. Treasury debt are considered the safest form of investing. These investments—known as fixed-income investments—provide steady income at a rate slightly higher than typical savings account from your bank. Protection comes from the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the strength of the U.S. government.

Stocks, corporate bonds, and municipal debt will move the investor up on both the risk and return scale. Stocks include large-cap, blue-chip companies such as Apple (AAPL), Bank of America (BAC), and Verizon (VZ). Many of these large, well-established firms pay a regular return on the invested dollar in the form of dividends. Stocks can also include small and startup companies that seldom return income but can return a profit in the appreciation of share value.

Corporate debt—in the form of fixed-income bonds—helps businesses grow and provide funds for large projects. A business will issue bonds with a set interest rate and maturity date that investors buy as they become the lender. The company will return periodic interest payments to the investor and return the invested principal when the bond matures. Each bond will have credit rating issues by rating agencies. The most secure rating is AAA, and any bond rated below BBB is considered a junk bond and is much riskier.

Municipal bonds are debt issued by communities throughout the United States. These bonds help build infrastructures such as sewer projects, libraries, and airports. Once again, municipal bonds have a credit rating based on the financial stability of the issuer.

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Mutual funds and ETFs are baskets of underlying securities that investors can buy shares or portions of. These funds are available in a full spectrum of return and risk profiles. 

Determining Your Risk Tolerance

Your risk tolerance is your ability and willingness to weather downturns in your investment choices. This threshold will help you determine how risky an investment you should undertake. It cannot be predicted exactly, of course, but you can get a rough sense of your tolerance for risk.

Factors influencing your tolerance include the investor’s age, income, time horizon until retirement or other milestones, and your individual tax situation. For example, many young investors can make back any money they may lose and have a high disposable income for their lifestyle. They may be able to invest more aggressively. If you are older, nearing or in retirement, or have pressing concerns, such as high health care costs, you may opt to be more conservative—less risky—in your investment choices.

Rather than investing excess cash in equities or other higher-risk assets, however, you may choose to keep greater allocations in cash and fixed-income investments. The longer the time horizon you have until you stop working, the greater potential payoff you could enjoy by investing rather than reducing debt, because equities historically return 10% or more, pretax, over time.

Pay Off Debts

Debt is one of those life events that most people experience. Few of us can buy a car or a home without taking on debt. Sometimes unforeseen events happen like medical expenses or the expense you may have after a hurricane or other natural disaster. In these times you may find you don’t have enough readily available funds and need to borrow money.

Besides loans for large purchases or unforeseen emergencies, one of the most common debts is credit card debt. Credit cards are handy because there is no need to carry cash. However, many people can quickly get in over their heads if they do not realize how much money they spend on the card each month.

However, not all debt is created equally. Keep in mind that some debt, such as your mortgage, is not bad. The interest charged on a mortgage and student loans is tax-deductible. You will have to pay this amount, but the tax advantage does mitigate some of the hardship. 

Interest on Debts

When you borrow money, the lender will charge a fee—called interest—on the money loaned. The interest rate varies by lenders, so, it is a good idea to shop around before you decide on where you borrow money. Also, your credit rating will affect how good of an interest rate you receive on a loan. 

Your lender may use compound or simple interest to calculate the interest due on your loan. Simple interest has a basis on only the principal amount borrowed. Compound interest included both the borrowed sum plus interest charges accumulated over the life of the loan. Also, there will be a date by which the funds must be paid back to the lender—known as the repayment date.

The interest charged on loans will usually be higher than the returns most individuals can earn on investment—even if they choose high-risk investments. When paying down debt, there are many schools of thought on what to pay first and how to go about paying it off. Again, a banker, account, or financial advisor can help determine the best approach for your situation.

Building a Cash Cushion

Financial advisors suggest that working individuals have at least six months’ worth of monthly expenses in cash or a checking account.   This safety cushion should be the first priority, but if your debt is too high, it may be impossible for you to accumulate that much money.

Advisors recommend that individuals keep a monthly debt-to-income ratio (DTI) of no more than 25% to 33% of their pretax income. This ratio means that you should spend no more than 25% to 33% of your income in paying off your debt. 

Balanced Budgeting

Paying off debt takes planning and determination. A good first step is to take a serious look at your monthly spending. Look at any expenses you can reasonably cut back on such as eating lunch out instead of brown-bagging a lunch. Determine how much you can save each month and use this money—even if it is only a few dollars—to pay off your debt. Paying down debt saves funds going toward paying interest that can then go to other uses.

Create a budget and plan how much you will need for living expenses, transportation, and food each month. Do your best to stick to your budget. Avoid the temptation to fall back into bad spending habits. Dedicate yourself to sticking to your budget for at least six months.

Methods to Pay Off Debt

Some advisors suggest paying off the debt with the highest interest first.   Still, other advisors suggest paying off the smallest debt first.   Whichever course you take, do your best to stick to it until the loan is paid.

Several different budgeting methods allow for both debt repayment and investments. For instance, the 50/30/20 budget sets aside 20% of your income for savings and any debt payments above the minimum. This plan also allocates 50% to essential costs—housing, food, utilities—and the other 30% for personal expenses.

Financial advice author and radio host Dave Ramsey offers many approaches to budgeting, saving, and investing. In one, he suggests saving $1,000 in an emergency fund before working on getting out of debt—paying off debt other than your home mortgage—as quickly as possible. Once all debt is eliminated, he advises returning to building an emergency fund that contains enough money to cover at least three to six months of expenses. Next, his plan calls for investing 15% of all household income into Roth IRAs and pre-tax retirement plans while also saving for your child’s college education, if applicable. 

Special Considerations – Taxes

The type of debt or type of investment income can play a different role when it comes time to pay taxes. Whether you pay off debt or use the money to invest, is a decision you should make from a number’s perspective. Base your decision on an after-tax cost of borrowing versus an after-tax return on investing.

As an example, assume you are a wage earner in the 35% tax bracket and have a conventional 30-year mortgage with a 6% interest rate. Because you can deduct mortgage interest—within limits—from your federal taxes, your true after-tax cost of debt may be closer to 4%. 

Student loans are a tax-deductible debt that can save you money at tax time. The IRS allows you to deduct the lesser of $2,500 or the amount you paid in interest on a qualified student loan used for higher education expenses. However, this deduction phases out at higher income levels. 

Income earned from investments is taxable. This tax treatment includes:

Should You Pay Off Your Debt or Invest?

The answer is: it’s complicated.

A common situation people face is deciding between paying off debt or investing. Both are admirable and necessary.

Paying off your debt means reduced stress, lower risks, and a greater ability to withstand personal emergencies. Living debt-free will also make it easier to endure an economic recession or depression, and you’ll have increased flexibility that can maximize personal happiness.

Investing means building a reserve that can protect you and your family and provide you with sources of passive income. Perhaps most importantly, it means accumulating enough money to retire comfortably.

What should you do? Theoretically, the most intelligent course of action when deciding between paying off your debt and investing should be to compare two variables:

  1. The rate of after-tax interest you are paying on your debt.
  2. The after-tax rate of return you expect to earn on your investment.

In other words, if you can earn a higher return on your investments than the interest on your debt, you should invest. Otherwise, you should pay off your balance. An illustration would be billionaire investor Warren Buffett purposely carrying a mortgage on his home in Omaha, Nebraska up until recent decades because he knew he could put the money to work elsewhere in his investment portfolio and make a lot more in the long run.

However, this is not always optimal once you’ve considered risk-adjustment. Instead, many financial planners these days recommend what I consider to be a more intelligent set of guidelines that provide the best of both worlds.

Which Debts to Repay and Which Investments to Fund

I suggest the following hierarchy:

  1. Fund any retirement account you and your spouse have at work, such as a 401(k) plan, up to the amount of any free matching money you receive. For many companies, matching amounts range between 50% and 150% of the first [x]%.
  2. Build your emergency fund in a highly liquid, checking, saving, or money market account. At least three months of expenses is a good guideline, but it’s OK to save even more.
  3. If you meet the eligibility guidelines, fully fund a Roth IRA for both you and, if you’re married, your spouse. You’d need to check the contribution limits in effect in any given tax year. For example, in 2020, a married couple earning less than $135,000 in adjusted gross income can contribute up to $6,000 of earned income per spouse ($7,000 per spouse if 50+ years old).
  4. Pay off any high-interest credit card debt, student loan debt, or other liabilities. Personally, I’d probably prioritize student loan debt because it can be the most difficult to discharge in bankruptcy. Keep at it until you are debt-free and stop adding to it at nearly all costs.
  5. Circle back around and contribute to your and your spouse’s 401(k) accounts up to the maximum amount permitted by your plan or the tax regulations.
  6. If you’re serious about retirement saving, look into a strategy that involves using HSA (Health Savings Accounts) as another type of de facto IRA on top of your Roth IRA.
  7. Begin building assets in fully taxable brokerage accounts, dividend reinvestment plans, directly held mutual fund accounts, or even buying other cash-generating assets. For example, a real estate investor could purchase apartment buildings, office buildings, industrial warehouses. You might also consider funding a college 529 savings plan for your children and/or grandchildren.

By behaving this way, you achieve several things:

  1. You minimize your tax bill, which means more money in your own pocket.
  2. You create significant bankruptcy protection for your retirement assets. Your employer-sponsored retirement plan, such as 401(k), has unlimited bankruptcy protection under the current rules, while your Roth IRA has $1,283,025 in bankruptcy protection as of 2020. (This will adjust upward again in April if 2020.)
  3. You reduce your debts over time. There comes a point at which they’re entirely repaid, and your free cash flow goes through the roof.
  4. You only make riskier investments in taxable accounts once all of your other basic needs are met. For example, if you have a lot of debt and a small retirement account, you probably shouldn’t be investing in IPOs.

Another Approach

Alternatively, it’s not a terrible idea to be completely debt-free, drawing a line around your assets so you never have to worry about having them taken from you. I know of people who eschewed any investing at all until they owned their own home outright, paid off college, and had built an emergency fund working ordinary jobs throughout their twenties and early thirties. By the time they were approaching middle age, they had a foundation that allowed their investable assets to soar, totally unrestrained by the financial demands that seem to haunt certain individuals and families in perpetuity. In other words, their answer was always to pay off debts first, then—and only then—begin investing. And for many people, this works out very well in the long run.

The Bottom Line: You Are the Variable That Matters

In the final analysis, my opinion is that behavioral economics needs to be factored into your decision. You have to decide between investing and paying off debt that 1. you can live with, 2. you’re likely to stick with until it’s completed, and 3. lets you sleep well at night. As long as you keep going, you should eventually get to the end-game objective, which is to have no debt and an abundance of great, lucrative investments providing a comfortable standard of living for your family. With enough patience and hard work, this is a goal that you can achieve.

Should I Pay Off My Mortgage or Invest?

Eric Huffman
Contributor, Benzinga

The average mortgage debt is just over $200,000, which is up nearly 10% since the housing crash. As an investor, you might face a conundrum: Is it a smarter move to pay off your mortgage or invest in general, and how does the math work?

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Quick Look: Should You Pay Off Your Mortgage or Invest?

  • There’s no clear winner – this depends on earning expectations and your mortgage terms.
  • You may want to pay off your mortgage early if you want to free up more cash. Paying off the principal feels great!
  • You want to invest if you believe in the power of index investing and are okay with taking on the risk.

Paying Off Your Mortgage…

When you buy a house (after October 2020), somewhere in the pile of papers you sign at closing, there’s a total interest percentage (TIP) and it spells out how much you pay in interest relative to the loan amount. (Earlier mortgages had a “finance charge” in loan documents.)

At 5% APR, the TIP for a $200,000 loan is over 90%, meaning an extra $180,000 will be paid in loan costs over the 30-year term of the loan.

Assuming you don’t have $200,000 in cash to pay off the mortgage, you might be considering extra payments. We can work with a conservative $100 per month as an extra payment, about $3 per day. Over a 30-year loan, the extra $100 per month will trim 5 years off the loan and save $37,000 in interest.

Here’s the real question: Can you make more than $37,000 in 30 years by investing $100 per month? Historically speaking, yes.

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… Or Invest?

Know someone who bought Google, Microsoft, or Apple in the early days? Or someone who saw his retirement savings cut dramatically in 2009? Investing can be equally as risky as it is rewarding. One of the safest routes is to follow a diversified index.

Index investing isn’t exactly new. The concept (and the first index mutual fund) dates back to the early 1970s when Vanguard introduced a fund that closely tracked the S&P 500.

Today, there are many alternatives that can also track the S&P 500 (like the best S&P 500 ETFs and S&P 500 index funds), a wide cross-section of the larger companies in the stock market; one of the most popular investment options is SPY, a low-expense exchange-traded fund. What’s interesting about index investing is not just that it’s easy; it often outperforms actively managed mutual funds.

You can easily track historical S&P performance to better understand what’s likely to happen in the long term. Individual stocks or more focused indexes may not have as much history or provide as much diversification in a single ETF or mutual fund. Historically, the S&P has delivered about a 10% return, including 7% real return and 3% from inflation.

The rate of return depends on the time frame. For example, the S&P dipped in 1928, 1930, 1954, and once again in 1982, 54 years after first visiting that level. Later years show the S&P’s dramatic rise, with several dips or crashes along the way.

Even in the decades where the S&P was essentially flat, reinvested dividends from the index made the investment worthwhile, helping to multiply the growth when the market began to grow rapidly. It’s impossible to know what will happen with the S&P index or any other investment over a 30-year time frame, but history tells us we can probably earn a 10% average annual return if we hold the investment and don’t sell at the first sign of trouble.

Using history as a guide, investing $100 per month in the S&P would net a nest egg of nearly $165,000 if you had started investing in May of 1988 and continued through May of 2020, the length of a 30-year mortgage. According to census data, the average home price in May of 1988 was $133,500. To be fair, interest rates were higher 30 years ago as well, topping 10% as an average for a 30-year fixed-rate mortgage.

90-year historical S&P chart

Advantages of Paying Off Your Mortgage

If you’re nearing retirement age or if you expect a change in your household income, it can make sense to pay off the mortgage to free up more cash each month, whether that’s a conventional mortgage or one that’s government-backed.

It’s also one less thing to worry about. Retirees, in particular, are likely to enjoy the freedom of not having a monthly mortgage payment and not needing to work part-time to make mortgage payments. T

he money saved by not paying mortgage interest diminishes later in the loan, however, with the payment toward interest in the last 10 years of the loan becoming just over half what it was at the start of the loan. In the last few years of a mortgage, nearly all of your mortgage payment goes towards principal. Paying off a mortgage late in the term does more for peace of mind than it does for financial gain through not paying interest.

Advantages of Investing

The primary advantage of investing instead of paying off your mortgage is that you’re building a liquid asset that has the potential to put you in a better financial position than if you simply eliminated your mortgage interest expense.

There aren’t any guarantees that your money will grow, but there is historical data that suggests your chances of earning more through index investing are very good, assuming an extended time frame. Short term investments often do not allow enough time for the market to recover from dips or downturns. Using data from a 30-year history of the S&P 500, investing $100 per month can create an investment portfolio worth over $160,000 over 30 years.

Disadvantages of Paying Off Your Mortgage

One of the only guaranteed returns we ever have in life is when we pay down debt. The gains are particularly strong when the debt is high-interest debt that isn’t tax-advantaged. If you have credit card debt at 15% interest, it’s unlikely that you can expect that kind of return from investments. Paying off the debt is the best move — and it’s paid with after-tax money, which makes it equivalent to a taxable investment that returns well above 15%.

The return on investment from paying down mortgage debt becomes less evident. Mortgage interest rates haven’t been at 15% for a long time. Rates hover at about 5%, so it’s difficult to imagine that you can’t earn a higher return by investing instead. Additionally, by paying off your mortgage early, you lose the mortgage interest tax deduction, which for most households serves to effectively lower the cost of mortgage interest. Depending on your tax bracket, the mortgage interest deduction might lower a 5% mortgage rate to about 3.5%.

Paying off your mortgage can also reduce your liquidity by putting more of your money into an illiquid asset. It’s not 2005 anymore and selling a home can take months, possibly requiring that you make price concessions or upgrades that cut into the cash you recover from the sale.

Disadvantages of Investing

An honest look at the performance charts for the S&P 500 show spans, sometimes decades-long, where little or no return was realized by investors. In some cases, investments are still upside down after 10 years or more. There aren’t any guarantees of a return on investment — with the exception of paying down debt, which always creates a return on investment.

Whether that return on investment from paying down debt is small or large depends on the interest rate and whether the interest is tax-deductible, like in the case of mortgage interest.

Final Thoughts

If historical averages are any indication of what investors can expect going forward, investing in an index, like the S&P 500, provides a significant financial advantage over paying down low-interest tax advantaged-debt, like a mortgage. There aren’t any guarantees, however, and some people may value security over a higher chance of return.

Paying off the mortgage accomplishes this. If you have enough spare money each month, you also have the option of doing both. In a best-case scenario based on historical averages, committing $100 per month to an S&P index fund can build a portfolio worth six figures over the next 30 years.

Committing another $100 per month to your 5% mortgage will reduce your mortgage length by over 5 years and save you about $37,000 in mortgage interest.

Want to learn more about investing? Check out Benzinga’s guides to the best online brokerages, best stock market books and best stock research tools.

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