Which came first, the chicken or the egg? If you can definitively answer this question of circular reasoning, you can probably answer the question of whether you should invest extra money or pay off debt first.
It’s largely a matter of opinion, however there are guidelines that make sense in this eternally burning question and there is actually some math that will help as well. Regardless of whether you invest any extra money or use it to pay off your bills, there are some considerations that should be taken into account before you do either.
There are three things that should be taken care of before you use any extra money for investing or paying off debt.
Be Current – If you are behind on any bills or delinquent in any kind of financial way, get current on these things first. Your credit rating can be negatively affected by delinquencies, not to mention the possibility of repossessions or foreclosure. Make sure your financial house is in order and stable before you take any more drastic measures.
Have a Safety Net in Place – This has long been a standard recommendation from wise financial counselors (there are many who are unwise). The rule of thumb is that you should have three to six months worth of savings in reserve just in case of emergencies. Layoffs, medical emergencies, and other unexpected things will happen in life. If you don’t have a safety net in place, Mr. Murphy says it is even more likely to happen.
Get Rid of High-Interest Debt – Before you go worrying about whether you should make extra payments on your mortgage, pay off the ridiculous revolving credit accounts that you have. Credit cards from retail stores or major credit cards with interest rates in the high teens to high twenties have got to go before anything else. The amount of the debt is irrelevant. The interest you are paying over time on these credit lines makes zero sense from a financially sound standpoint.
Do the Math
After you have taken care of the basics outlined above (and if you haven’t, then the rest of this article should be for future reference only), then it actually becomes a question of math to determine where your extra funds should flow.
With each financial decision you need to make, the basic question is obviously “which is better for me?” The way to decide this from a strictly monetary standpoint is by determining the after-tax return for an investment versus the after-tax expense for a debt.
Each debt that is paid off is in fact a gain for you in the long run because of the interest which is eliminated. As an example, if you have a mortgage on your home, your rate is probably somewhere in the 4.5-7.5% range.
You may be below or above this range, but the majority will fall somewhere in here. At face value, paying off your mortgage will save you this percentage of interest each year on the amount that you owe on your home. However, this is not necessarily the case.
Because of the tax deduction on mortgage interest, your effective interest rate is actually less than what you think it is by probably a percentage point or two.
If your effective rate winds up being, say, 4.5% yearly, then when deciding between paying this off and investing you have to determine if your investment will have returns at a rate greater than 4.5%. It is really just that simple.
Finding an investment that has returns at a greater rate than an effective mortgage rate is not that difficult if you do some homework. Any investor worth his salt expects to make a better return than this. Traders expect even higher rates of return.
I will rarely enter a trade if I don’t expect at least a 10% return from it, and I look for a 20% return usually. Even conservative investments should outpace most effective mortgage rates.
If the interest you are looking at is on a loan that does not have tax advantages, then the comparison becomes less advantageous to the investment argument. If you are comparing an interest rate that is less than 10%, you should be able to justify investing or trading, unless you are new to the game and need to learn more.
Once the interest rate breaks the 10% mark (this mark is arbitrarily set by my own opinion), then investing becomes less of an option, while trading (well) remains an option to at least 12-15% in my opinion. These levels will differ depending on your experience and level of comfort.
Lower Your Stress Level
While all of this sounds well and good from a mathematical point of view, we are all still human and emotions and stress m
ust be taken into account. Not everyone will comfortable with the idea of investing as opposed to paying off bills or debt, let alone the rates of return that I’ve suggested above.
Well-being needs to be taken into account above pure numbers. If you decide that based on the math the investing or trading route is the way you should go, but you can’t sleep at night worrying about whether your investments will tank on you, you should pay off your debt instead.
The market will still be open when you are out of debt. Psychological peace of mind is essential to your health, as stress is a top killer because it causes so many other health issues.
Assess your situation both by the numbers and according to your level of comfort before you make any serious decisions. There is an answer, but it is completely dependent on you.
Take the Free Money and Run
One last note on investing: If your job offers you matching funds on a 401(k) or other similar option, fund it fully. This should not be an option.
Your money is usually taken pre-tax, and if your company is matching your funds then you are getting a 100% return on that money before it even enters the market.
While I don’t necessarily endorse mutual funds per se, doubling your money before the fund managers ever get their hands on it certainly increases your potential for earning versus losing by quite a bit.